In any business there are three possible ways to improve gross your contribution margin , these are:
Increase sales volume
Raise selling prices
If the outputs of your business are services rather than physical products, this can be restated as:
Increase the quantity of services provided
Raise unit charges, for example hourly fee rates.
Sometimes marketers use more sophisticated terms than these, for example, they may refer to:
Changing the product mix
Altering the gross profit mix of product range
Changing the customer mix
But each of these variations are the three basic strategies to improve the contribution margin.
Why not just lower prices?
Stagnant or shrinking markets could be characterized by intense competition. Many businesses operate in these markets by trying to maintain or increase their sales volumes by lowering their selling prices to meet competition. This in turn reduces the gross margin on every product sold.
For example, in Table 1 the first column shows a profit plan for one year, assuming a selling price of $10 per unit sold.
The second column is an alternative plan showing what the business hopes to achieve in the same year, but this time with the selling price per unit reduced by 10% to $9 to meet the competition.
If your business consists of service products rather than physical products, then the unit price shown in the tables will need to be converted to service hours charged.
In practice however, the strategy of lowering and selling prices is very dangerous.
1. Little volume increase: In an intensely competitive market situation it is most likely that competitors are also reducing their selling prices, that's a price war in progress.
Accordingly, instead of increasing sales by 15,000 units as in the second column of Table 1, it is probable that the business will achieve little if any increase in volume as a result of reducing its prices by 10%.
2. Indirect costs increases: In Table 1 it is assumed that indirect costs will remain constant at $200,000 when unit volume increases by 15,000 units. In practice however, an increase in volume cannot rarely be achieved without a greater input of indirect costs. This is particularly so in a highly competitive market.
For example, extra expenditure will be required on items such as advertising and other promotional costs, salesmen's commission and salaries and distribution costs.
These projected factors have been built into table 2 where it is assumed that the following events what occur if the business reduced it selling price by 10%:
1. Sales volume would rise buy 4% from 50,000 to 52,000 units.
2. Indirect costs would rise by 5% from $200,000 to $210,000 as a result of the greater input required to achieve the 4% increase in sales volume in the highly competitive market which the business operates.
The numbers in the second column of Table 2 are indicative of the disastrous results of a business which reduces selling prices in a bid to increase sales volume, while operating in a highly competitive market.
In the table below we refer to contribution margin as gross profit (same thing just different terminology).
Further problems caused by inflation: At this point we also need to consider the further the complications caused by inflation. In a high inflation situation both the direct and indirect cost of the business (as shown in Table 1 and Table 2) will typically be increasing.
These increased costs can be financed from two possible sources, these are: 1. Net profits earned by the business 2. Cash injection from outside borrowings
But as shown in the second column of Table 2, lowering selling prices in a competitive market situation reduces net profit. Table 2 shows that the business would have made a net loss of $2,000 if prices had been reduced by 10%. In these circumstances the business would need to borrow more funds from outside sources to finance increases in operating costs in the following year.
A business which attempts to maintain or increase volume by reducing selling prices in an intensely competitive/ high inflation situation may suddenly find it has little if any net profit remaining.
Alternatives to lowering prices: The three methods you can use to raise the contribution margin of your business, are therefore:
Increase sales volume
Raise selling prices
Stay focused and key your eye on the contribution margin.