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The Importance of Contribution Margin

As advisers to businesses in financial difficulty we are often called into meetings to help Directors focus on what is important in their turnaround/restructuring plans.  We regularly help these discussions progress by focussing on contribution margin.

It is very common to hear the turnaround/restructuring plans focusing on the blue sky coming from that next big sale that is just around the corner, with the gross proceeds of the sale being rationalised as the panacea to the current overdue creditor problem.

It’s in moments like these that we ask the Directors to focus on the contribution margin that the next big sale is going to generate. The contribution margin represents the profit, after deducting direct costs, that is left available to cover the fixed costs of the company.

When Directors of companies that are struggling to pay their debts don’t set aside an adequate provision to cover the direct and indirect costs associated with the sale, they don’t have a clear impression of the impact of the sale on creditors.  In these circumstances, they can start to walk the tightrope leading towards an insolvent trading claim.

As a simple illustration: Company A owes $10 to overdue creditors, but can make a sale for $10, where the direct costs of the sale are $5, then the contribution margin is $5. However, if the sale takes 1 week to complete and in that time the weekly indirect overheads of Company A are $5, then there is no net contribution towards the $10 overdue creditors that existed at the start. Ultimately, if the $10 is applied to the overdue creditors, the fresh credit that was incurred that was not paid is potentially an insolvent trading claim in the making.

We understand that evaluating the cash flows of businesses in financial difficulty is hard but making sense of these cashflows is something that turnaround/restructuring advisers like Heard Phillips Lieberenz can help with.