A Method for Aligning Cash Flow and Contribution Margins More Effectively

Publication Date01 March 2015
DOIhttp://doi.org/10.1002/jcaf.22028
Date01 March 2015
AuthorReginald Tomas Lee
1
© 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

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