21 Jan Business Alchemy Lesson 10–How Much Pie Do You Get? (Contribution Margin)
Once you have put together the total amount of pie that will be eaten for the meal by determining the fixed and variable, you can then get around to the original question of how much pie you get for yourself.
If I determine that there are 15 pieces of pie that will be consumed by my family and there are 20 total pieces of pie, then there are five pieces of pie left for myself, right? The amount of pie left is my NET PROFIT.
The same is true for your business. Once you have figured out your fixed and variable expenses, you can subtract them from your total sales (total number of pieces of pie) to determine what is left–your NET PROFIT.
But suppose that my mom wanted to know how much pie to make in order to feed the whole family. Just like projecting profit, this is when it gets tricky without the correct tools.
In this situation, what I do is begin with what I do know again. Let us change the scenario a little. Because the variable eaters eat a percentage of the pie based on the amount made, if my mom makes more pie, then the variable eaters will eat more pie. Also, let us assume that the percentage consumed is directly related to the total pie produced, in other words, the same percentage of pie is consumed regardless of the amount produced.
We can then take all of the pie (100%) and subtract the amount consumed by the variable eaters (we will say 66%) and come up with the percentage of the total pie that is left for the fixed eaters (33%). Because you know how much fixed pie will be consumed, you know the minimum amount that has to be left for everyone but me to eat pie.
Stay with me here as I go through some algebra. I knew my wife, each of my three kids and my mother would each have one piece of pie, these are my fixed numbers, so five pieces. The amount left after the variables then has to be five pieces. In other words, five pieces has to be not more than 33% of the total pie available. So if 5=.33x, then you divide both sides by .33 and the result is fifteen pieces of pie. 5 pieces is 33% of 15 pieces.
You must have 15 pieces of pie for everyone else to get pie. So now we know that when there are more than 15 pieces of pie made, I get whatever is left. In the example above, when 20 pieces are made, I get five pieces of pie for myself, right?
Wrong! Remember that as more pie is made, the variables increase as a percentage. So this scenario is a little bit different than the scenario given initially, because in that scenario, we said we knew the variable eaters were going to eat 15 pieces of pie. In this scenario, if five more pieces are produced, 33% of those extra pieces are available for me to eat, or about 1.67 pieces (5 X .33), because we have already served the five pieces that we needed for the fixed eaters as part of the original 15 pieces, which means that once the fixed eaters have been served, the 33% of each additional piece is now available for me (profit).
This is how you can use variable and fixed expenses as a tool. When you subtract the variable expense percentage from the total sales (which is always 100%), then the resulting percentage is what is known as the contribution margin (33% above). This percent is the total amount left to cover–or contribute to–your fixed expenses and profit.
The contribution margin percentage can then be used to figure out the bare minimum that you have to sell in order to have zero profit (no pie for me), but still pay all of your bills (fixed eaters). This is know as your break-even point. That is one tool you now have from this discussion.
The second tool is profit projection. Say I want two pieces of pie for myself–which would be a profit of two. You add the desired profit to the fixed expenses–in this case five pieces, and solve the same way as before to figure out the total pie needed. 7=.33x, so divide 7 by .33 to get 21 pieces of pie. In other words, there must be 21 pieces of pie for me to get two full pieces of pie for myself.
So there you have it. Contribution Margin, Break-Even and Profit Projection. These tools are very basic tools to understand profit and of course you already know that…
Without Foundation, your business fails!