What is a KPI?
Key Performance Indicators, or KPI’s as they are known in the business world, are critical to a business’s success. Key Performance Indicators are a critical indicator of progress toward an end result or goal in business. These KPI’s illustrate a business’s strengths and areas needing improvement. KPI’s serve as tools that a business can and should use to measure how effectively and efficiently a business is meeting its key objectives. There are several KPI’s that vary by business but one of the most critical and overlooked is the Contribution Margin.
Put quite simply, contribution margin is the revenue a company has left over after all variable expenses are deducted. An overall contribution margin can be calculated, or a contribution margin by item can be calculated. Both calculations serve a purpose.
The contribution margin shows how much profitability a business has for each item sold and serves to show how much money is left over to pay for fixed expenses after variable expenses are deducted. If contribution margins do not equal or exceed a businesses fixed expenses, then there is a loss for the period that was used to calculate the contribution margin.
Price, Volume, and Optimal Production
The goal of any business should be to decrease fixed expenses such as rent or insurance to maximize the contribution margin. A healthy contribution margin will help a company determine whether it should increase its selling price per item. Having a low contribution margin means a business does not have a lot of money to spend on increasing sales. Having a higher contribution margin, one the other hand illustrates that a company has extra money to spend on marketing and advertisement, which in turn will increase sales. Increasing sales will, in turn, increase the contribution margin.
The Effect of Contribution Margin
Contribution margins drive many decisions in business, including whether or not a business is ready to scale larger. The size of the contribution margin determines if a company has enough money to increase unit sales through advertising. A larger contribution margin means a company can be willing to spend to increase sales.
On the contrary, a lower contribution margin means a company may not have the money to spend to increase sales. Contribution margin drivers how a company spends money on marketing and advertisement and also determines how a company adds or reduces fixes costs.
A company with a higher contribution margin, such as a Mattress Company (low manufacturing cost high profit margin), can spend millions on advertising each year as is evident why there are always mattress sales going on in every store you go to. A company with a lower contribution margin, such as a kitchenware company, does not spend much money on advertising because they have a lower amount of money to spend.
In the end, as a key performance indicator, the contribution margin helps a company reach its goals by illustrating how well the company is performing from a margin standpoint. It allows the company to determine how much profit is in each unit sold and how much money is left over after variable expenses.
This key performance indicator is often overlooked when it comes to the importance of KPI’s but from the information in this article, it can be inferred that contribution margin should be one of the first KPI’s a company considers when making business decisions from an accounting perspective.