BLOG

Insightful opinions and timely responses to the most important business issues facing the craft beer industry. Crafting A Strategy members have access to additional blog content from our founders and from industry experts in marketing, financial modeling, economics, and business strategy.

Blog

Why Contribution Margins Matter

Kevin O'Brien - Guest Expert

There are certain core financial ratios that any small business owner should understand in order to better manage their business – gross margin %, debt to assets, accounts receivable turnover, etc. One ratio that is often overlooked but proves to be immensely useful is the contribution margin. Understanding this concept is important because your contribution margin is what allows you to cover your fixed costs and generate a profit. Additionally, understanding your contribution margins will allow you to make better decisions as to where and how you sell your products.

Revenue minus variable expenses is the definition of a contribution margin. Whereas revenue less the input costs to produce a case of beer results in the gross margin, the calculation of the contribution margin factors in the additional costs to actually sell the product – the additional variable expenses. If the contribution margin does not exceed a company's fixed expenses, it does not make a profit. A company that has a contribution margin that is less than its fixed expenses incurs a loss.

As a small business owner, you are aware that there is a lot more to your business than just selling your product for more than it cost to produce. There are certain costs that are incurred regardless if you sell a product (fixed costs) and other costs that are incurred as part of selling your product (variable costs). To understand the concept of contribution margin, it is important to understand the differences between fixed and variable costs.

In order to be in business there are certain expenses that are required. These costs don’t vary with the level of output of the business; they are recurring expenses that are also known as overhead. Common examples of fixed costs include rent, utilities, office supplies, permits, and insurance. Regardless of the amount of products sold, these costs are “fixed” in their nature and need to be covered by the business owner.

Variable expenses are costs that increase or decrease relative to the amount of product sold. Said another way, these are the costs that are incurred in order to complete the sale of the product. Examples of variable costs include broker commissions, shipping expenses, distribution allowance, etc. As sales of products increase, these costs increase as well, hence the name “variable” expense.

With this basic understanding of fixed vs. variable costs and how they relate to contribution margins, an owner can now better evaluate sales opportunities. It is well known that certain sales channels (tap room) have higher gross margins than others (distribution). While it does make sense to try and generate the highest gross margin possible it is equally important to understand the variable costs that are associated with completing the sale.

For instance, let’s assume that you sell a 22oz. bomber via the taproom for $10 and in distribution it is $5. Assuming a production cost of $2 per bomber, the gross margins by tap room and distribution would be $8 and $3, respectively. At first glance, it seems obvious that you’d want to sell as much as possible through the taproom in that the gross margin is much larger. However, in order to properly make that determination it is important to evaluate the additional variable costs incurred to complete the sale.

Let’s assume that the variable costs incurred to sell the six-pack in the taproom were $7 (staffing, utilities, samples, etc.) while the variable costs to sell through distribution are $1. Once these costs are factored in, it appears that it is actually more profitable to sell your bottle through distribution than through the taproom in that the contribution margin is $2 per bottle as opposed to $1 per bottle. The extra $1 of contribution margin per bottle is that much more money you will have to cover the aforementioned fixed expenses.

Keep in mind that there are certain fixed costs that rely on the variable costs of selling product in a certain manner. An example would be if an owner spent considerable funds on retrofitting a taproom only to close it a year later because sales didn’t meet expectations. Without selling product through the tap room this cost cannot be recovered and therefore adds that much more pressure to increase contribution margins in other channels. The same situation occurs if a long-term lease is signed and the owner cannot find someone to take it over, this is now a “sunk” cost that must be recovered through other sales channels.

The above is an example of why it is important to understand the concept of contribution margins. Business owners who assume that a higher gross margin is better for their business may find themselves in financial difficulty because they aren’t considering the additional costs to complete the sale. If nothing else, understanding contribution margins will allow you to justify why one sales channel is worth focusing on relative to another.

About Kevin O’Brien, CPA: Guest Expert Blogger for Crafting A Strategy, Kevin is Director of Business Advisory for Irvine & Company CPA’s, specializing in financial modeling, strategic planning, and mergers and acquisitions. Kevin has been involved on both the buy and sell side of over $250 million in food & beverage transactions.

Irvine & Company CPA’s: Certified Public Accounts 345 NE 102nd Ave, Portland, OR, Phone 503-252-8449

Weight: 

0

Give Me Profitability And Give Me Death

Sam Holloway, Ph.D. – Crafting A Strategy

Apologies to Patrick Henry…I just returned from a great week in Denver and the 2014 Craft Brewer’s Conference. It was great to reconnect with old friends, meet new ones and attend some great sessions. One session in particular, “Surviving Rotating Handles” really struck a nerve for me. Congrats and thanks to E3 Craft Strategies’ Marty Ochs for putting together a talented and spirited panel.

For those of us at the panel, we saw some passionate folks who fundamentally disagree on the future. Marty constructed a panel representing the traditional 3-tiered system: Representing breweries was a great brewery co-founder from Elevation Beer Co., Xandy Bustamante. Representing distributors was an old-school brand manager from Philadelphia, Tom Buonanno from Muller, Inc. distribution. And perhaps the most passionate of them all, representing retail was Scott Blair, proprietor of Hamilton’s Tavern in San Diego. What an awesome crew to highlight an impending problem facing the craft beer industry. – Brewers and consumers want variety, but distributors want more sameness. More sameness is more profitable, could chasing profits result in the death of distribution, as we know it?

At Crafting A Strategy, we are business professors who studied many different industries before finding our true love in craft beer. I want this blog to focus in on the role of the distributor – or rather the distributor business model – to explain that distributors may need to wake up and reinvent their business model to survive (Johnson, Christensen, & Kagermann, 2008). Why would this cash cow of a business need to change? Eastman Kodak, Bethlehem Steel, Woolworth’s Department Stores… any of these companies ring a bell?

Clay Christensen and Michael Raynor (2003), have a wonderful book, The Innovators Solution, that shows how leading companies follow the profits to their ultimate demise. Chapter 2 – How Can We Beat Our Most Powerful Competitors, details a particularly important phenomenon, which they term “Fleeing up-market.” This process occurs within an industry’s most powerful firms, when these powerful firms chase short-term profitability found in their traditional business model, and ignore disruptive technologies and processes found in the business models of new entrants. Here’s an example from the steel industry (adapted from Christensen and Raynor, 2003).

Bethlehem Steel, U.S. Steel, remember the dominance of these large, integrated steel mills? Even the Pittsburgh Steelers NFL team celebrates this business model. They had incredible barriers to entry[1], because the only way to manufacture high quality steel was to own large deposits of iron ore. If you own all the good land, no new competitors can get this critical input and thus, you have a dominant market position. How could new entrants get around this barrier to entry? A new entrant, NUCOR Steel, found a way to recycle scrap steel and thus gain the critical input without owning large deposits of iron ore. This new business model was termed “Minimills” because they could be much smaller and more efficient than traditional steel mills that were doing things the old way (Christensen & Raynor, 2003). The only problem, minimill processes were initially crude, and they could only make the most basic and least profitable kind of structural steel, rebar (see chart below). So, what did Bethlehem Steel and the large integrated steel mills do when this new technology for steel production threatened their very livelihood? They let NUCOR have all the rebar – its margins are the lowest and least profitable – and they kept going along as if NUCOR had done them a favor. Imagine the conversation in the boardroom: Bethlehem CEO, “Don’t worry about minimills like NUCOR, their process is crude, they will never be able to make structural steel or sheet steel, just give them the rebar and let us redeploy all of our resources into the higher margin stuff. They are doing us a favor!” In the back of his mind, the Bethlehem CEO may have said, “Since my bonus is tied to share price, and I plan to retire in two years anyway, this strategy will also maximize my retirement, a win-win!” Guess what, Wal-Mart entered in hardware and Woolworth’s let them have it. Fujifilm, Canon, Sony and Nikon entered in digital cameras, and Eastman Kodak let them have it. Sticking with Steel for now, see Christensen’s chart below as to how this decision to “let the new entrants have it” and flee up-market without changing the business model led to incredible profitability, for a few years. Ultimately, NUCOR refined and improved their processes, and was able to make all of the products in the steel industry, cheaper, faster, and at the same or better quality. Bethlehem fled up-market until they were dead firm walking! Bethlehem Steel filed for bankruptcy in October 2001.

Caption: Generic Pattern of Disruption as Incumbent Firms “Flee Upmarket”
Source: Image courtesy of Magpixie under Public Domain 

So now, back to the Marty Ochs’ panel at the 2014 CBC. Distributors are the kings of the castle. Better capitalized, better efficiency, more and better relationships, they seem unbeatable. But on either side of them in the 3-tiered system are partners screaming for a different business model. Rotating handles, variety, appealing to consumer tastes, lower profitability…the brewers and retailers are innovative, looking for a better way, and always told to just keep things the same and it will be better for all of us. Why so resistant to change? I mean, these distributors have been around much longer than craft breweries. Bright, successful people run them. They have better experience and way more information – how many of us small craft breweries can afford Symphony IRI data, after all. How can distributors fail?

Distributors rely upon market research for decision-making – many use IRI data. The fundamental assumption of market research is that the past is a good predictor of the future. Has your distributor ever suggested to you that you go into six-pac glass instead of aluminum cans “because the data shows 96% of all six-pacs are in glass”? What if Oskar Blues had listened to the past instead of forging their own future in cans? Retailers, brewers, and consumers care about variety and are trying to create a future of rotating handles where there previously was no market. There is no past, no market research that they can rely upon to ‘research’ how the rotating tap market might look. Market research is useless to them… But they are forging ahead anyways because they believe variety and choices among quality products is the right thing to do…so what will the future look like?

Something has to give. If Christensen and Raynor (2003) are correct, maybe the rotating handles phenomenon is the rebar of the craft beer industry. Existing distributors will ignore the market demand, let someone else gain a foothold in the market and leverage their sunk costs in existing trucks and warehousing practices, to reap the immediate profits, right into their own demise. A new entrant, with a passion for variety and an understanding of the needs of places like Elevation and Hamilton’s, may bring new technologies and processes to market, perhaps a cleverly designed truck technology – that automatically delivers 1/6th bbl kegs and gathers empties using a conveyor system. Will current distributors continue to ignore these changes in consumer tastes? I sure hope not, but with 10,000 breweries by 2020, the business model of distribution better get ready for change.

References

Christensen, C. M. & Raynor, M. E. 2003. The innovator's solution: Creating and sustaining successful growth: Harvard Business Press.

Johnson, M. W., Christensen, C. M., & Kagermann, H. 2008. Reinventing Your Business Model. Harvard Business Review, 86(12): 50-+.

 

[1] For more on barriers to entry, members can view our white paper, “Threat of New Entrants”

Weight: 

0

Welcome from Kevin O’Brien, CPA

It is with great excitement that I post my first blog entry for CRAFTINGASTRATEGY.COM. Sam and I have known each other for several years so when he asked me to consider blogging for his new venture I jumped at the chance. As a CPA (and home brewer) with a particular focus on the alcoholic beverage industry, I am excited to become part of a program that is supporting the growth of an industry that I have long admired. Sharing a passion for the craft beer industry, Sam and I have enjoyed several pints discussing different aspects of the craft beer industry – where it’s been, where it’s going and more importantly, how we can help. We are both strongly committed to leveraging our experience to assist entrepreneurs in accomplishing their craft brewing dreams.

With many years of experience working with wineries/breweries/distilleries from the start-up phase to over $100 million in revenue, I am excited to share my insight with the CRAFTINGASTRATEGY community. I’ve always enjoyed the numbers and operational drivers behind a great business strategy. My work history has included working on both the buy and sell side of the acquisition equation, helping buyers look for the right kind of company and also helping sellers position their company as an attractive target. Additionally, working at an alcoholic beverage focused CPA firm has allowed me greater insight into specific tax strategies; record keeping best practices, requirements for bank financing and more.

My focus on the CRAFTINGASTRATEGY member’s only blog will be giving you the mindset and the tools to structure and analyze your company from a financial perspective. Here is a look at upcoming blog posts for the next 6-8 months:

  • Contribution margins and business model development
  • Cash is king, the importance of cash flow
  • Using financial models to understand where the profits lie
  • Why good recordkeeping is crucial
  • Valuing your business model as multiple profit centers
  • Positioning your company for a sale, key thoughts on valuation and how to maximize value

 

As stated above, I am very excited to be supporting the craft beer industry through the CRAFTINGASTRATEGY community. I hope that my posts provide some food for thought in the financial arena and allow you to look at your business from a different perspective. I look forward to being a resource to all members in order to help in the continued success of this great industry!

About Kevin O’Brien, CPA: Guest Expert Blogger for Crafting A Strategy, Kevin is Director of Business Advisory for Irvine & Company CPA’s, specializing in financial modeling, strategic planning, and mergers and acquisitions. Kevin has been involved on both the buy and sell side of over $250 million in food & beverage transactions.

Irvine & Company CPA’s: Certified Public Accounts 345 NE 102nd Ave, Portland, OR, Phone 503-252-8449

Weight: 

1

Pages