It is quite easy and very fast to use the Total Contribution formula to calculate the business’s profit. And then, to figure out how to increase profit. Let’s take a look how to do it step by step.
Profit = Total Contribution – Fixed Costs (FC)
Specifically, Total Contribution is simply Contribution Per Unit multiplied by the Quantity produced and sold:
Total Contribution = Contribution Per Unit x Quantity
Or:
Total Contribution = [Price – Average Variable Cost (AVC)] x Quantity
So:
Profit = [Price – Average Variable Cost (AVC)] x Quantity – Fixed Costs (FC)
How can Contribution Analysis help to increase profit?
Both Contribution Analysis and the formula for Profit suggest two broad strategies for improving business profits.
Profit = Sales Revenue – Total Costs (TC)
The profit of any business organization can be increased either by increasing Sales Revenue or decreasing Total Costs (TC), or by doing both.
1. Increase Sales Revenue:
- Increase Quantity sold. Sell more products as this raises Total Contribution. Managers can attract more customers to increase Sales by using appropriate marketing strategies, e.g. innovate new products, enter into new markets, target new market segments, change promotion methods, etc., or growth strategies, e.g. opening more shops, hiring more sales personnel, taking over another business, etc.
- Change the price. The business can either increase the price or decrease the price. For elastic products managers should decrease the price to sell more while for inelastic products they should increase the price to boost Sales Revenue. In addition, either increase the price for complementary products, or decrease the price for products that are substitutes.
2. Decrease Total Costs (TC):
- Reduce Variable Costs (VC). Lower the cost of production.
– Lower raw materials costs. Managers can do it by negotiating better deals with current suppliers or finding new suppliers who offer lower prices of raw materials. Another way is to use cheaper raw materials or use less raw materials to make products, e.g. offer smaller size hamburgers in the restaurant while charging the same prices as for bigger ones sold previously. However, this may impact product quality and customer satisfaction.
– Lower wages for production workers. This can be done either by decreasing wages per piece or per hour to production workers, or reducing the number of workers who make products. Alternatively, hiring cheaper workforce, but this approach may have negative impact on long-term productivity and quality.
– Lower packaging costs. Instead of using two or three different types of wrappers to package the product, the production department can replace excessive packaging with only one layer. Alternatively, the firm may ask some of its customers to come and pick up the products in person which will eliminate the need for any packaging to be used. This will allow the business to reduce packaging costs to 0.
– Use economies of scale. Managers can seek more cost-effective production methods such as producing many products in one batch rather than making each product individually. By using assembly lines to mass produce products firms can lower Average Variable Cost (AVC), thereby helping to raise Contribution Per Unit made from selling each unit of output.
- Reduce Fixed Costs (FC). Lower Indirect Costs (Overheads) of the business. You can do it by better financial control or the use of Cost Centers and Profit Centers. Generally, reducing monthly expenses will boost profit.
– Lower rent. Either negotiate for cheaper rent with the landlord, or simply rent smaller premises. Very often businesses have extra space that is unused and redundant, but must be paid for on monthly basis. Another way to lower rent costs is to relocate the business outside the city center where the cost of land is much lower.
– Lower salaries for managers. Similarly to lowering wages for production workers, the business can either decrease salaries for its managers or reduce the number of managers who work in the business. Alternatively, hiring cheaper managers is also an option, but this approach may have negative impact on how properly the business is being managed. One more method could be delayering.
– Lower interest on a bank loan. Very often banks are willing to renegotiate interest on bank loans issued to the business when interests rates change in the economy. Another option is to change the lender as interest rates on bank loans vary between banks. The business can also pay off the bank loan earlier, if possible, in order to completely reduce interest payments to 0. But, check with your bank first to see, if there is a penalty for paying off your business loan early.
– Lower administrative costs. Limiting extravagant company expenses such as flying economy instead of business class, hiring cheaper security firm, renegotiating all sorts of insurance, etc. can effectively lower the administrative Overheads without actually negatively impacting the quality of products. Lots of possibilities in this area.
In summary, increasing profit is a very basic task for business managers. And thanks to Contribution Analysis, maximizing earnings through these two broad strategies for improving Profit is now easier than ever.
