A business unit should be closed if it consistently under-performs, has a net operating loss, and will likely continue to do so in the future. This statement sounds true – this should be an easy decision. Closing the business unit, however, could be exactly the wrong thing to do and could end up hurting a firm’s bottom line.
In order to determine if this business unit should be closed or not, the firm must first determine if the business unit contributes to offsetting the firm’s fixed costs. The cost-volume-profit analysis concept of contribution margin is how this is done.
Contribution margin is the revenue of the business unit minus the variable costs of operating the business unit. Variable costs are costs that could be saved in the short term if the business unit were closed. Contribution margin is the money the business unit has left over that contributes towards paying fixed corporate overhead costs after paying these variable costs. For the A/E industry, the following equations can be used to calculate the contribution margin and net operating profit of a business unit.
Contribution Margin = Revenue – Direct Expenses – Variable Overhead
Net Operating Profit = Contribution Margin – Fixed Overhead
- Variable Overhead expenses are indirect expenses that are directly attributable to the business unit (salaries, marketing, etc.) or expenses that can be saved if the business unit were closed (indirect salary costs for technical staff shared across business units that can be reduced, etc.)
- Fixed Overhead expenses are indirect expenses that are not directly attributable to the business unit and will not change in the short term if the business unit were closed (rent, corporate overhead expenses, etc.)
If contribution margin is greater than zero, the business unit contributes to offsetting fixed costs and should not be closed for purely financial reasons, even if the net operating profit is negative. The following example illustrates this point.
| 1. Bus. Unit A | 2. Bus. Unit B | 3. Firm (A+B) | 4. Firm (Without A) | |||||
| Revenue | $10,000 | 100% | $50,000 | 100% | $60,000 | 100% | $50,000 | 100% |
| – Direct Expenses | ($5,000) | -50% | ($15,000) | -30% | ($20,000) | -33% | ($15,000) | -30% |
| – Variable Overhead | ($3,000) | -30% | ($10,000) | -20% | ($13,000) | -22% | ($10,000) | -20% |
| = Contribution Margin | $2,000 | 20% | $25,000 | 50% | $27,000 | 45% | $25,000 | 50% |
| – Fixed Overhead | ($3,000) | -30% | ($15,000) | -30% | ($18,000) | -30% | ($18,000) | -36% |
| = Net Operating Profit | ($1,000) | -10% | $10,000 | 20% | $9,000 | 15% | $7,000 | 14% |
- The firm has two business units. Business Unit A is the smaller of the two and has a net operating loss. Should Business Unit A be closed?
- Business Unit A has a positive contribution margin of $2,000 but its $3,000 allocation of fixed corporate overhead costs causes it to operate at a loss with a net profit margin of -$1,000.
- The fixed overhead expenses of the firm are $18,000. The firm has to pay these fixed costs whether they are operating with or without Business Unit A.
- With both business units operating, the firm has a net operating profit of $9,000, a 15% profit margin (column 3 above). If the firm closes Business Unit A, it will reduce its net operating profit to $7,000 and profit margin to 14% (column 4 above). This $2,000 difference in net operating profit is the contribution margin of Business Unit A.
- The firm will be worse off if it closes Business Unit A so the firm should not close Business Unit A, even though it is operating at a loss. The concept of contribution margin can help prevent the firm from making a costly mistake!