LEVERAGING CONTRIBUTION MARGIN TO GAIN A COMPETITIVE ADVANTAGE

Introduction

Financial institutions are increasingly utilizing contribution margin as a means of not only measuring profitability performance, but also as a tool to assist in making daily pricing decisions. When used as a measurement of profitability reporting, contribution margin more clearly

shows how cost behavior impacts profitability. Since many of the functions an operational manager performs depends on a firm understanding of costs, taking a contribution margin approach when reporting profitability focuses the user directly on fixed and variable cost behavior. When utilizing contribution margin to facilitate pricing decisions, a user can pinpoint the exact price point that must be achieved to cover variable costs, and then contribute toward covering fixed costs and ultimately creating profits.

Definitions

The classification of expenses as fixed, variable and semi-variable defines how an expense will behave over a relevant range of volume during a pre-defined time period (usually one year). If the concepts of relevant volume ranges and time are discarded, it can be argued that all expenses are semi-variable. In other words, at some volume level during some period of time all expenses will increase (or decrease) as volume increases (or decreases).

The incorporation of volume ranges and time requires a "run/rise" analysis when defining whether an expense is fixed, variable or semi-variable. This type of analysis defines the "run" as the relevant range of volume over which the associated expense will remain stable. The "rise" is the magnitude of the increase (or decrease) the expense will experience once the relevant range of volume is surpassed. The following diagram illustrates "run" and "rise":

Fixed Expenses remain stable over the largest relevant volume range, which means that it takes a significant volume increase or decrease before these expenses are impacted. This yields the longest run and highest rise on the run/rise step curve. While fixed expenses stay flat as volume is increased within the relevant volume tolerance range, fixed unit costs actually go down within the same tolerance range. The opposite is true when volume decreases within the relevant volume tolerance range defined for the fixed classification. To illustrate, let's say an expense stays flat at $100 per year during years 1 and 2. Volume, on the other hand, increases from 10 items to 20 items. The resulting per item unit costs will drop from $10 ($100/10) to $5 ($100/20) since the fixed expense is assigned to a larger number of items. Examples of fixed expenses or resources include occupancy or large equipment devices, such as reader-sorters in Check Processing or CPUs in IT. Operations management is usually also considered a fixed production cost.

Variable Expenses vary in direct relation to each unit of volume. Expenses move directly with volume increases (or decreases) in a linear fashion and therefore have no volume tolerance ranges. The linear nature yields a line to define the relationship between expenses and volume rather than a run/rise step curve. When expressed as a unit cost, the variable cost component remains constant, regardless of the relevant volume. Examples include postage, EPN fees for ACH transactions, certain supplies and per-item presentment fees to the Fed or Correspondent Banks for check clearing.

Semi-Variable Expenses fit logically into a relevant volume tolerance range between the fixed classification and the variable classification. This yields a shorter run and rise on the run/rise step curve than fixed expenses, but more than the linear nature of variable expenses. While these expenses don't vary with volume increases or decreases directly, they do change on a smaller scale and within a smaller defined relevant volume tolerance range than fixed expenses. A good example of semivariable expenses is salaries and benefits for personnel, where increases or decreases can be one or very few FTEs at a time within a tighter relevant volume tolerance range than fixed.

Contribution Margin - This term assumes only variable and fixed cost classifications and defines what remains from total sales revenues after deducting variable costs. The remainder can be used to contribute toward covering fixed expenses and profits for the period. The semi-variable component is a key to business analyses, such as staffing models and capacity planning. However, for ongoing profitability measurement in a monthly production environment, the semi-variable component can be associated with the variable and fixed components to simplify analysis, including the contribution margin calculation. Typically, the semivariable component can be split 60% fixed and 40% variable unless a detailed analysis determines an alternate split. With the contribution margin calculation, it is important to understand that revenue is not always required to cover the fixed cost component.

Using Contribution Margin for Reporting and Measuring Profitability

Many banks today use a full absorption approach when evaluating product profitability. As a result, included are all costs directly associated with producing a product (variable, semi-variable and fixed), as well as any transferred costs from other areas (e.g. finance, sales, admin, etc.), and an allocated portion of bank overhead not directly related to the cost of providing the service (e.g. audit, board of directors, tax, etc.)

When utilizing a full absorption approach, all incurred costs, including direct, support and overhead costs are divided among bank units. Banks define units of cost differently, usually dependent on the complexity and size of the institution. For example, banks can allocate costs to line of business segments, divisions, departments, products, customers, and accounts. The goal is to allocate costs at the approximate level of resource consumption.

The full absorption methodology is based on the idea that any unit's use of a bank's resource bears with it an opportunity cost to the institution because it precludes the use of those same resources to support other bank units. Consequently, if a unit's profitability cannot be demonstrated on a fully absorbed cost basis, the resources should be redeployed to other profitable units.

The biggest problem with this approach is that costs are included that are typically out of the product manager's control. Thus, if costs are allocated on a fully absorbed basis, operating inefficiencies or unused capacity in other departments may be included in a product's cost allocation. For example, if a bank has available reader/sorter capacity that is not being utilized, the lockbox product would bear an allocated portion for the cost of this underutilized equipment. Product managers argue that fully absorbed costs adversely affect the presentation of product profitability and may cause products to be eliminated when, in fact, they produce a profit contribution to the bank.

A solution to this inherent problem is to utilize the contribution margin approach when measuring and reporting product profitability. This approach is becoming more widely used as an internal planning and decision-making tool. An emphasis on costs by behavior facilitates cost-volume-profit analysis. The approach can also be a very useful tool in appraising management performance, budgeting, and facilitating numerous special decisions, such as product line analysis, pricing and make or buy analyses.

Unlike the full absorption approach, the contribution margin approach does not require that all expenses be allocated to the reporting units of an institution. The contribution margin approach focuses on marginal revenue and marginal costs and allows undistributed expenses to remain at different levels of reporting. Advantages of this approach include:

* Cost allocations are primarily based on activity/cost drivers

- By focusing on activity or cost drivers, the credibility and accuracy of cost allocations are greatly enhanced. The cost x volume distribution technique supports a usage driven charge to product revenues.

* Accountability - Product managers are held accountable for expense they alone control or on which they have an influence. Expenses are included in reporting only at the level they become controllable.

* Better information -The resulting management information is viewed as better for product management and marginal pricing decisions as only those costs directly related to the product are used in the analysis.

The contribution margin approach can also be used when a bank is attempting to build business for new products or when the institution has available unused capacity. This is based on the premise that by covering direct production costs (which, at a minimum, would include variable costs); some marginal contribution to profit is made. If we assume that overhead will be incurred regardless of whether another unit is produced, then it is better to have some marginal revenue contribution toward overhead than to have none at all. Exhibit 1 shows two different levels of product profitability reporting.

Using Contribution Margin for Making Pricing Decisions

Competitive considerations are critical in bank pricing strategies, particularly within Treasury Services. In practice, bank prices are based as much on competitor pricing as on the bank's own costs. Pricing tends to be one of the more sensitive and difficult problems facing bankers. Most bankers agree pricing should cover costs, but most also agree that pricing is primarily market-driven. So how can we reconcile these opposing positions? Using contribution margin when making pricing decisions can help balance these two positions and ultimately help an institution maximize profitability in at least three significant ways:

* Capacity Management - By utilizing contribution margin, an institution can focus on utilizing available unused operational capacity. And by filling available unused capacity, an institution can reap the benefits of operating as efficiently as possible and maximizing economies of scale.

* Lowering Fixed Unit Costs - By increasing volumes, fixed unit costs across the board are lowered. Not only does this benefit products whose resource pools can be directly traced to the product, but products that utilize shared resource pools benefit as well. An example would be the lockbox product benefiting by lowered unit fixed costs from check processing when significant additional pre-encoded deposited items are sold.

* Competitive Advantage - Having fixed, variable and semivariable cost information available to help make pricing decisions empowers the sales force to be as competitive as possible when bidding on new business. This gives the institution a distinct competitive advantage.

Pricing Continuum

Credible management information is the key component when making a pricing decision. Information in this instance is defined as both market-based and cost-based information. We'll focus here on the cost-component. Cost-based intelligence is not only unit cost knowledge (e.g. variable, semi-variable and fixed components) but also knowledge of operational capacity and capacity constraints. Once this information is known and understood, the sales force becomes empowered to utilize the "pricing continuum ". Note: To simplify presentation, semi variable costs have been allocated 40% to variable costs and 60% to fixed costs. As such, only variable and fixed costs will be shown on the next four exhibits.

The pricing continuum is a tool utilized by a sales force to competitively price services. An artful use of this tool is crucial to remaining competitive in today's banking environment. In Exhibit 2 we can see an example of a hypothetical pricing continuum for a processed check. The continuum clearly shows where this product can be priced and the associated costs. The price floor for this product is its variable cost ($0.0175). A bank would not normally price below variable cost unless it was attempting to build volumes to mature levels or if it were attempting to gain market-share. Even if an institution elected to offer this product as a loss leader or had available unused capacity, it would still not normally price below VC. Any price above $0.0525 per item contributes to not only covering fixed costs, but ultimately profits as well. Notice the flexibility of pricing at the margin. We have a range from $0.0175 to $0.0525 with which to negotiate a price with a potential customer. We know exactly how low we can go and what pricing will do to product and customer profitability. This information, coupled with industry-wide market pricing information can give financial institutions a competitive advantage.

Contribution Margin and a More Balanced Financial Scorecard

A scorecard is a measurement system designed to assess the degree of success in implementing a business strategy. It is designed to a have a range of performance measures that better reflect what an organization needs to be successful. In general, there are three or more measures. In banking, these measures are typically new sales, revenue growth and net profit. However, competitive pricing often results in a deal being negative on a scorecard from a net profit perspective. As such, one would be less inclined to do the deal, even if contribution margin existed. It should be noted that pricing at the margin can cause some seemingly contradictory impacts on a scorecard. As an extension of the previous example consider Exhibit 3 below.

Note that in this example the product "checks deposited" appears to be a loss leader since, on a fully-absorbed basis, we have a pretax margin per item of ($0.0110). Consider a new deal opportunity of 10,000,000 additional items. The deal can be priced three different ways as per Exhibit 4.

Pricing below variable cost (price point 1 @ $0.015) would result in a negative contribution margin and is not where one would typically want to be on the pricing continuum. Pricing to cover both fixed and variable costs (price point 3 @ $0.055) is desirable, but perhaps not practical for certain products and/or certain markets. Pricing at the margin (price point 2 @ anywhere from $0.0175 - $0.0485) becomes an attractive alternative. In the example, pricing at the margin is set @ $0.03. Notice that price point 1 is the only point that we have a negative contribution margin. Now let's consider the impacts of these three price points on pretax income in Exhibit 5.

In this example, we have created a situation that sends a mixed signal. At the price point of $0.03 we have increased contribution margin, but actually decreased our pretax margin (at least on a fully allocated basis). We'll assume that we will not incur any actual additional fixed costs to bring on the new customer as we have available unused capacity. So we have created a situation where it is not clear how to proceed. From a shareholders perspective the message might be to "do the deal". No additional fixed costs will be incurred and each additional item is contributing $0.125 toward covering fixed costs and profit. From a banker's perspective, it is not so clear. Since most banker scorecards do not yet contain a contribution margin metric, we're left with a negative impact to net income or pretax margin (a metric that is on most banking financial scorecards).

A Simple Solution

Most banking scorecards tend to be quantitative in nature rather than qualitative. Quantitative meaning the focus is on getting new business and growing current customer share of wallet, irrespective of the quality of the new business (e.g. how profitable or how much contribution margin is generated by the new business).

A typical banking scorecard might look like Exhibit 6. Note the heavy emphasis on quantity. New sales and revenue growth typically accounts for well over fifty percent of a typical bank financial scorecard. The emphasis here is on "making the sale".

An alternative scorecard might look like Exhibit 7 where there is a more balanced approach of financial measurement with an equal emphasis on generating more business and ensuring that the business is profitable. The introduction of the contribution margin metric changes the entire nature and emphasis of the scorecard.

Caveats and Conclusions

When using contribution margin for reporting purposes or for making pricing decisions it is important to be aware of potential caveats. Bankers should ask the question, "What true additional costs are associated with this new volume?" for each potential new deal. To determine profit contribution, the products position on the stepped cost function should be carefully evaluated. Eventually, the marginal cost of the new volume will be quite costly, such as adding the cost of another reader/sorter machine for check processing.

As such, using contribution margin should not necessarily be a carte blanche nod to price every large deal at the margin. Doing so could potentially leave significant revenues on the table and would be a foolhardy strategy. However, a more thoughtful approach using contribution margin on selected products for selected targeted customers can provide additional profits for a financial institution, utilize available unused capacity and give an institution a competitive advantage.