Analyze Your Profit Contribution
Trying to maximize profit contribution can conflict with trying to grow your business. In other words, do you want profit or growth?
Of course, you want both. Unfortunately, one of these goals comes at the expense of the other.
Maintaining a balance of mailings to your customer file (where the profits come from) versus mailing to prospects is critical to your bottom line. How do you evaluate contribution from mailings to the housefile and catalogs you circulate to prospects?
This month, I’ll discuss the incremental break-even point compared to a fully absorbed break-even point as they relate to contribution to profit and overhead.
See the definition on this page for what contribution to profit and overhead means. The formula is:
gross sales - returns = net sales - cost of goods sold - direct selling expenses - variable order-processing costs = contribution
A positive contribution to profit and overhead exists if there are excess funds available after the formula has been applied. To calculate contribution, you must know the cost of the catalog (in the mail), your customer returns ratio, gross margin ratio and variable order-processing costs. Once you have this information, you can determine contribution to profit and overhead from the mailings.
Using this approach you can easily discern the revenue per catalog needed to break even on an incremental basis (before overhead expenses). Determine the contribution from all mailings. It’s up to your finance department to apply overhead expenses to determine the overall profitability of the company.
See the chart “Proforma Contribution Statement” on page 36. The example is based on printing 1.2 million catalogs for a holiday mailing (a consumer gift catalog). The overall revenue per catalog is $2.10 per book, and the average order size is $60.
We used a 3.79-percent returns ratio, and a cost-of-goods percentage of 47. Direct selling expenses are $740,780, or $0.617 per catalog. This produces a 30.5 percent selling expense to sales ratio, typical for a consumer catalog.
Note: The incremental column excludes overhead expenses such as rent, salaries and utilities. Assume the variable order-processing costs are $5 per order. The incremental contribution to profit and overhead from this mailing was $336,071, or 13.8 percent of net sales.
This amount can contribute and be applied to the profit and overhead. When you apply the overhead expenses (i.e., fully absorbed basis), the pre-tax profit amounted to $133,307, or 5.5 percent of net sales. Overhead expenses amounted to $412,763, or 17 percent of net sales.
As the 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—variable order processing is part of total overhead expenses. It’s the incremental cost to process an order, and not the total cost to process an order on a fully absorbed basis.
In the example, the actual incremental break-even point is $1.44 per catalog mailed. Based on the costs shown in the chart, you must generate $1,733,538 in gross revenue to achieve incremental breakeven. Again, actual results are considerably greater than the incremental break-even point, which is good news. Most likely, you can afford to do more prospecting.
To calculate the incremental break-even point, divide the direct selling expenses plus variable order processing expenses (S.G. & A.) by 53 percent (gross margin percentage). This gives you the amount of net revenue needed to break even. This number must be factored up to include returns at 3.79 percent to give you the gross demand revenue break-even point.
It’s easy to calculate contribution, but it’s more difficult to achieve a positive number when prospecting. Mailings to prospects must be evaluated on an incremental basis (before overhead expenses are applied). Prospecting results are unlikely to 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 you’d increment yourself into the poorhouse! It’s the housefile that must cover overhead expenses, and evaluate mailings to the housefile on a fully absorbed basis.
When prospecting, strive to cover only your incremental (out-of-pocket) expenses. This means you’re adding new buyers to your file at no expense to the company. A calculation for incremental breakeven follows:
net sales - cost-of-goods sold - direct selling expenses - variable order-processing costs = incremental breakeven
It’s not easy to achieve incremental breakeven when prospecting, especially if you’re in a growth mode. Most catalogers have to make an investment in acquiring new buyers. But trying to circulate too many catalogs is when catalogers tend to get into financial trouble.
How Much is Enough?
The answer depends on your business model. Discern what contribution ratio you need to achieve your desired profitability.
Look at the proforma 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 being applied to the total overhead expense of this mailing.
How to use this information: Assume you don’t need to earn 5.2 percent pre-tax profit. Perhaps you’re willing to earn 3 percent or just break even on a fully absorbed basis. You can increase mailings to prospects to grow more rapidly. On the other hand, if you want to increase profitability, you can reduce your prospecting. Using a proforma contribution statement like this enables you to adjust your circulation to determine the effect on the bottom line. Knowing the amount of contribution for every mailing will help your business stay healthy.
Stephen R. Lett is president of Lett Direct, a catalog consulting firm specializing in circulation planning, forecasting and analysis. He can be reached at (302) 541-0608, or by e-mail at firstname.lastname@example.org.