To run a company successfully, you need to know everything about your business, including its financials. One of the most critical financial metrics to grasp is the contribution margin, which can help you determine how much money you’ll make by selling specific products or services.
More importantly, your company’s contribution margin can tell you how much profit potential a product has after accounting for specific costs.
Below is a breakdown of contribution margins in detail, including how to calculate them.
What is a contribution margin?
A contribution margin represents the money made by selling a product or unit after subtracting the variable costs to run your business.
Consider its name — the contribution margin is how much the sale of a particular product or service contributes to your company’s overall profitability. It’s how valuable the sale of a specific product or product line is.
Related: How to Price Your Staffing Services
In a contribution margin calculation, you determine the selling price per unit (such as the sales price for a car) and subtract the variable cost per unit or the variable expenses that go into making each product.
You may need to use the contribution margin formula for your company’s net income statements, net sales or net profit sheets, gross margin, cash flow, and other financial statements or financial ratios.
What does a contribution margin tell you?
The contribution margin is one of the critical parts of a break-even analysis. A break-even analysis is a financial calculation weighing costs of production against the unit sell price to determine the break-even point, the point at which total cost and total revenue are equal. Break-even analysis can help you with risk management
Break-even analyses are useful in determining how much capital you’ll need for a new product and calculating how much risk will be involved in new business activities. They are often used to determine production cost and sales price plans for different products, such as:
- How much you should price specific products for.
- How many products you need to sell to turn a profit (the number of units can determine whether you have a low contribution margin or high contribution margin).
- How much product revenue you will generate.
The contribution margin further tells you how to separate total fixed cost and profit elements or components from product sales. On top of that, contribution margins help you determine the selling price range for a product or the possible prices at which you can sell that product wisely.
Other things the unit contribution margin tells you include the following:
- Profit levels you can expect from the sales of specific products.
- Sales commission structures you should pay to sales team members.
- Sales commission structures you should pay to agents or distributors.
How to calculate a contribution margin
Luckily, you can calculate a contribution margin with a basic formula:
C = R – V
“C” stands for contribution margin. “R” stands for total revenue, and “V” stands for variable costs. With these definitions, the equation goes like this:
Contribution margin = total revenue – variable costs
Note that you can also express your contribution margin in terms of a fraction of your business’s total amount of revenue. The contribution margin ratio or CR would then be expressed with the following formula:
CR = (R – V) / R or contribution margin = (total revenue – variable costs) / total revenue
Fixed costs vs. variable costs
Crucial to understanding contribution margin are fixed costs and variable costs.
Fixed costs are one-time purchases for things like machinery, equipment or business real estate.
Fixed costs usually stay the same no matter how many units you create or sell. The fixed costs for a contribution margin equation become a smaller percentage of each unit’s cost as you make or sell more of those units.
Variable costs are the opposite. These can fluctuate from time to time, such as the cost of electricity or certain supplies that depend on supply chain status.
Contribution margin example
Imagine that you have a machine that creates new cups, and it costs $20,000. To make a new cup, you have to spend $2 for the raw materials, like ceramics, and electricity to power the machine and labor to make each product.
If you were to manufacture 100 new cups, your total variable cost would be $200. However, you have to remember that you need the $20,000 machine to make all those cups as well. The machine represents your fixed costs.
Now imagine that you make those cups to be sold at three dollars per unit. You can now determine the profit per unit by plugging in the above numbers:
- SP – TC = Profit per unit, where SP is the sales price, and TC is the total cost.
- $3 – $2 = $1 profit per unit.
In this example, the profit per unit is the same as the contribution margin. It’s how much each cup sale contributes to “real” profits.
How can you use contribution margin?
You can use contribution margin to help you make intelligent business decisions, especially concerning the kinds of products you make and how you price those products.
A contribution margin analysis can help your company choose from different products that it can use to compete in a specific niche based on available resources and labor.
Related: Determining Your Break-Even Point
For instance, you can make a pricier version of a general product if you project that it’ll better use your limited resources given your fixed and variable costs.
You can also use contribution margin to tell you whether you have priced a product accurately relative to your profit goals.
For instance, if the contribution margin for a specific product is too low, that could be a sign that you need to either increase the price as you sell the product. It could also indicate that you need to reduce the variable (i.e., manufacturing and supply-related) costs associated with that product to turn more of a profit.
Contribution margin compared to gross profit margin
Contribution margins are often compared to gross profit margins, but they differ. Gross profit margin is the difference between your sales revenue and the cost of goods sold.
When calculating the contribution margin, you only count the variable costs it takes to make a product. Gross profit margin includes all the costs you incur to make a sale, including both the variable costs and the fixed costs, like the cost of machinery or equipment.
Related: How to Calculate Gross Profit
Furthermore, a contribution margin tells you how much extra revenue you make by creating additional units after reaching your break-even point.
Put more simply, a contribution margin tells you how much money every extra sale contributes to your total profits after hitting a specific profitability point.
This is one reason economies of scale are so popular and effective; at a certain point, even expensive products can become profitable if you make and sell enough.
When should you use contribution margin?
Generally, you should use contribution margin to tell you:
- If you have priced a product incorrectly.
- How many products you need to sell to make a profit based on variable costs.
- Whether you need to reduce operating or labor expenses related to making a product.
A negative contribution margin tends to indicate negative performance for a product or service, while a positive contribution margin indicates the inverse.
However, it may be best to avoid using a contribution margin by itself, particularly if you want to evaluate the financial health of your entire operation. Instead, consider using contribution margin as an element in a comprehensive financial analysis.
Use contribution margin alongside gross profit margin, your balance sheet, and other financial metrics and analyses. This is the only real way to determine whether your company is profitable in the short and long term and if you need to make widespread changes to your profit models.
Related: Understanding the Difference between Gross Margin and Markup
You may also use contribution margin as an investor. Investors and analysts use contribution margins for a company’s staple or primary products.
They can use that information to determine whether the company prices its products accurately or is likely to turn a profit without looking at that company’s balance sheet or other financial information.
For instance, if a company has a low contribution margin for its essential products, it could be spending more money than it is bringing in.
Conversely, a good contribution margin may indicate that the company is an excellent operation and uses its resources wisely.
Related: The 5 Myths of Mastering Profit Margins
So, what are the takeaways about contribution margins?
As you can see, contribution margin is an important metric to calculate and keep in mind when determining whether to make or provide a specific product or service.
Once you calculate your contribution margin, you can determine whether one product or another is ultimately better for your bottom line. Still, of course, this is just one of the critical financial metrics you need to master as a business owner.
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