Determining Contribution to Profit and Overhead
by Stephen Lett
Like most catalogers, we strive to maximize the amount of contribution to profit and overhead generated from the mailings we make. Attempting to maximize profit contribution can (and often does) conflict with trying to grow your business. In other words, do you want profit or, do you want growth? I know what you are saying. That is, you want both! Unfortunately, one of these goals comes at the expense of the other. Maintaining a balance of mailings to your customer file (which is where the profits come from) vs. mailings to prospects is critical to your bottom line success. So, how do we evaluate contribution from mailings to the house file and from catalogs we circulate to prospects? This month, we will discuss the incremental breakeven point compared with a full absorbed breakeven point as they relate to contribution to profit and overhead.
First, let’s be sure we know what contribution to profit and overhead means. It is defined as follows. Contribution is the amount of money leftover to contribute to overhead expenses after we deduct for customer returns, cost-of-goods sold, direct selling expenses and variable order processing costs. Our formula is as follows:
|Gross Sales minus Returns = Net Sales minus cost of goods sold minus direct selling expenses minus variable order processing costs = Contribution|
A positive contribution to profit and overhead exists when there are excess funds available after this formula has been applied. A negative contribution to profit and overhead occurs when there is a shortfall.
In order to calculate contribution, we need to know the cost of the catalog (in-the-mail), the customer returns ratio, the gross margin ratio and our variable order processing costs. Once we have this information, we can determine the contribution to profit and overhead from the mailings we make. Using this approach, we can easily determine the revenue per catalog needed to breakeven on an incremental basis (before overhead expenses). We don’t want to turn marketing people into bean counters yet it is important for us to determine the contribution from all mailings. It is up to the finance department to apply actual overhead expenses in order to determine the overall profitability of the company.
A typical contribution statement is as follows:
|PROFORMA CONTRIBUTION STATMENT|
Actual Quantity Printed:
|Quantity to be Mailed:||1,170,000||INCREMENTAL
|Rented Names Mailed:||289,000|
|Coops Names Mailed:||560,000|
|Less: Returns & Allowances||$91,980||3.79%||$91,980||3.79%|
|Less Cost of Goods Sold||$1,141,169||47.00%||$1,141,169||47.00%|
|Less Direct Selling Expenses:|
|2). Printing and Paper||$0.210||$252,000||10.38%||$252,000||10.38%|
|4). Rented Lists - Lists||$0.120||$34,680||1.43%||$34,680||1.43%|
|5). Rented Lists - Databases||$0.070||$39,200||1.61%||$39,200||1.61%|
|7). Order Form||$0.013||$15,600||0.64%||$15,600||0.64%|
|8). Ink-Jet and Mailing||$0.010||$11,700||0.48%||$11,700||0.48%|
|Total - Direct Selling Expenses||$0.617||$740,780||30.51%||$740,780||30.51%|
|Less Operating Expenses:|
|1). Overhead Expenses||$0||0.00%||$412,763||17.00%|
|2). Variable Order Processing *||$5.00||$210,000||8.65%||$0||0.00%|
|Total - Operating Expenses||$210,000||8.65%||$412,763||17.00%|
|Total S.G. & A.||$950,780||39.16%||$1,153,543||47.51%|
|Contribution to Corporate||$336,071||13.84%||$133,307||5.49%|
|Revenue Per Catalog||$2.10||$2.10||$2.10||$2.10|
|* Variable Order Processing is the incremental cost for processing 42,000 orders.
This cost is included in the total overhead expenses shown in Fully Absorbed column.
This example is based on printing 1.2 million catalogs for a Holiday mailing (a consumer gift catalog). Our overall revenue per catalog is $2.10 per book and our average order size is $60. We have used a 3.79% returns ratio and a cost-of-goods percentage of 47%. Our direct selling expenses are $740,780 or $.617 per catalog. This gives us a 30.5% selling expense to sales ratio which is fairly typical for a consumer catalog company. Note the incremental column is before any overhead expenses such as rent, salaries, utilities, etc. We have assumed our variable order processing costs are $5.00 per order. The “incremental” contribution to profit and overhead from this mailing was $336,071 or 13.8% of net sales. Simply put, this means that our mailing generated this amount of money which can contribute and be applied to the profit and overhead of the company. When we apply the overhead expenses, i.e., fully absorbed basis, the pre-tax profit from this mailing amounted to $133,307 or 5.5% of net sales. Overhead expenses amounted to $412,763 or 17.0% of net sales. As our footnote explains, variable order processing is the incremental cost for processing 42,000 orders. This cost is included in the total overhead expenses shown in the fully absorbed column. In other words, variable order processing is part of total overhead expenses. It is the incremental cost to process an order and not the total cost to process an order on a fully absorbed basis.
In our example, the actual incremental breakeven point is $1.44 per catalog mailed. Based on the costs shown in our chart, we need to generate $1,733,538 in gross revenue in order to achieve incremental breakeven. Again, our actual results are considerably above our incremental breakeven point which is good news. Most likely, we can afford to do more prospecting. In order to calculate the incremental breakeven point, we divide the our direct selling expenses plus variable order processing expenses (S.G. & A.) by 53% which is our gross margin percentage. This gives us the amount of net revenue we need to breakeven. This number needs to be factored up to include returns at 3.79% in order to give us our gross demand revenue breakeven point.
It is easy to calculate contribution but it is much more difficult to achieve a positive number when prospecting. I have always felt that mailings to prospects must be evaluated on an incremental basis (before any overhead expenses are applied). Simply put, it is not reasonable to think that prospecting results will yield enough return to cover overhead expenses. Prospecting must be looked at on an incremental basis. On the other hand, all mailings can’t be incremental or we could incremental ourselves into the poor house! It is the house file that must cover the overhead expenses. In summary, we look at prospecting on an incremental basis and we evaluate mailings to the house file on a fully absorbed basis.
When prospecting, we strive to cover our incremental (our out-of-pocket) expenses only. Achieving this goal means we are adding new buyers to our file at no expense to the company. Again, remember our definition of incremental breakeven which is:
|Net Sales minus cost-of-goods sold minus direct selling expenses minus variable order processing costs = Incremental Breakeven|
Keep in mind that it is not easy to achieve incremental breakeven when prospecting especially if you are in a growth mode. Most catalogers do have to make some investment in acquiring new buyers. How much you are willing to spend to acquire a new buyer depends on the financial strength of the company and on how deep your pockets are. This is where catalogers tend to get into financial trouble trying to circulate too many catalogs. Maintaining a balance between mailings to your house file vs. mailings to prospects is important and being careful NOT trying to grow too fast.
With regard to contribution, how much is enough? Well, that obviously depends on your business model. It is really a question of determining what contribution ratio you need to achieve your desired profitability. Let’s look at our chart again. On an incremental basis, this holiday mailing generated a positive contribution to profit and overhead ratio. It was enough contribution to yield a nice pre-tax profit after we applied our total overhead expenses to this mailing.
So, how can we use this information to help us know what to do? Let’s assume you don’t need to earn 5.2% pre-tax profit. Perhaps you are willing to earn 3.0% or even breakeven on a fully absorbed basis. That’s fine. You can therefore increase mailings to prospects in order to grow more rapidly. If on the other hand you want to increase profitability, then, you can easily reduce the amount of prospecting you do. Using a proforma contribution statement similar to the one in our example enables you to adjust your circulation in order to determine the affect on the bottom line.
It is important that a proforma contribution statement be prepared for each and every mailing you make. This will help maintain profitability. What’s more, a proforma will serve as the budget or goal for every mailing so you will have some basis for comparison. Knowing the amount of contribution for every mailing you make will help your business stay healthy, wealthy and wise!