A Method for Aligning Cash Flow and Contribution Margins More Effectively

• Published date: 01 March 2015
• DOI: http://doi.org/10.1002/jcaf.22028
• Date: 01 March 2015

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© 2015 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).

DOI 10.1002/jcaf.22028

Reginald Tomas Lee

Making sound

decisions

regarding tak-

ing on new business is

critical for any busi-

ness: In some cases,

it can make or break

your company. This is

true whether you are

a one-person shop or

a multi-billion dollar

company. We regu-

larly look for ways to

gain an advantage, whether it is

finding new and different infor-

mation, or understanding how

flexible you can be with pricing.

Cash is king, and increas-

ingly, companies are looking to

contribution margin rather than

the cost of goods sold (COGS)

to understand the cash implica-

tions of taking on new business.

Historically, the gross margin

and the unit margin played this

role. Gross margin, the aggregate

difference between revenue and

COGS, and the unit margin, the

equivalent at the unit level, pro-

vided insights into whether the

company was generating a profit

and, therefore, cash.

There are two challenges

associated with gross margin,

however. First, COGS is not

effective at determining the cost

to produce a product. Although

COGS includes costs that are

assigned directly to products

or services such as labor and

materials, it also includes val-

ues that have nothing to do

with the product or service. For

example, one company included

warehouse costs in the cost of

manufacturing products because

they shared space with manu-

facturing, but these costs are

not directly involved with the

production of the product. For

another company, all products

received the same overhead cost,

although the steps and materi-

als required to manufacture

them were significantly differ-

ent. When costs such as these

are included in the calculated

cost to manufacture a product

or perform a service,

it skews our under-

standing of how

many resources the

product or service

actually consumed.

The second

problem is that the

costs used to calcu-

late COGS are not

aligned with the rate

at which cash flows.

For instance, assume

you spend money on labor and

materials for products you cre-

ate today and put into inventory.

There was cash spent, of course,

but the cost does not show up

on the income statement as

COGS until the product is sold

from inventory. Additionally,

COGS requires an arbitrary

assignment of costs to calculate,

and this assignment has nothing

to do with the amount or timing

of cash flow.

To illustrate how calculated

cost values have little to do with

cash flow, consider the difference

between long-distance phone

calls versus local calls. When you

used to buy phone service, you

would start with buying monthly

local service. This gave you full

access to making as many local

Making sound decisions about new business

can make or break a company. But accounting

approaches to contribution margin models are

inaccurate from a cash-flow perspective: They’re

too generic and don’t model cash flows properly.

As this article illustrates, by modeling your cash

flow and capacity while looking at decisions on

a case-by-case basis, your analysis can become

much more effective. © 2015 Wiley Periodicals, Inc.

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A Method for Aligning Cash Flow and

Contribution Margins More Effectively