Knowing your overall contribution margin is beneficial because it can be compared to prior periods to determine if it is trending positively or negatively. Additionally, contribution margin analysis can be applied to individual products, product lines, services, or service lines. Knowing the contribution margin of a particular product or service can help determine if carrying that product or performing that service over another is the best decision. Moreover, understanding contribution margin is very helpful in developing the best pricing strategy for your business.

One final benefit to knowing how to determine contribution margin is that it can point out your most profitable products or services, even though sales may indicate something different. For example, if product A has sales of $100K and product B has sales of $80K, it would appear, based on total sales alone, that product A is the more attractive product to emphasize. But a quick contribution margin analysis reveals that product B contributes 0.49 cents of every sales dollar to covering fixed costs vs. product A’s 0.34 cents. Clearly, product B is a real contributor and should be part of this retailer’s product mix.

Operating Leverage

In gaining an understanding of operating leverage, let’s reconsider our hypothetical auto body shop owner. She has seen her maintenance and service expense increase because of all the additional use her machinery is getting due to a recent and significant up-trend in sales.

She is faced with a decision: should she invest in additional fixed assets to handle the additional sales volume or just continue with her current fixed asset platform?

Without understanding operating leverage, this business owner doesn’t have valuable information that could help her make the best decision. Operating leverage is the degree to which a business uses fixed costs to generate profit. The greater the degree of fixed cost reliance, the greater the increase in profits during a sales up-trend and the greater the loss in a sales down-trend.

As fixed assets usually carry fixed costs, financed payments for the equipment, additional insurance, etc., investing in additional equipment is something our auto body shop owner will want to seriously consider if the up-ward sales trend she is experiencing is something she believes to a be long-term phenomenon. If she believes the sales up-trend to indeed be long-term, then investing in additional fixed assets may be just the thing for her to do.

CVPA is one tool our auto body shop owner can use to help her determine what to do in this situation. By using her break-even model and considering contribution margins, she can perform sensitivity analyses to help her determine whether or not to increase her operating leverage in an effort to take advantage of a sales up-trend. Summary

CVPA is a tool that can be used to help answer questions you may have about pricing your products and services, whether or not to invest in additional capital items, and which products and services to emphasize. While there is no one magic bullet, CVPA is a nice tool to have in your business analysis bag to help you make good decisions when answering these types of questions.

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