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Contribution margin is used to help measure product profitability. Business owners generally use the contribution margin ratio on a per-product basis to determine the portion of sales generated that can contribute to fixed costs. After covering fixed costs, the leftover revenue is the profit. If the margin is negative, the company is losing money producing the product.
What is contribution margin?
The contribution margin is the selling price per unit minus the variable cost per unit. It’s a financial metric that calculates the incremental money generated for each product or unit sold.
The variable portion of the firm’s costs is deducted from the revenue. Variable costs refer to costs that change when volume increases or decreases. Some examples include raw materials, delivery costs, hourly labor costs and commissions.
In contrast, fixed costs, as the name suggests, stay constant and are independent of production volume. Think rent, insurance and salaries.
Let’s look at a simple example. If a company sells computer chairs for $300 and the unit variable cost is $180, the unit contribution margin is $120.
Contribution margin analysis
The contribution margin measures how much money each additional sale contributes to a company’s profits. It helps business owners measure product profitability and understand how sales, variable costs and fixed costs all influence operating profit. The larger the contribution margin, the better, as it indicates more money to apply to fixed costs. What’s leftover after variable and fixed costs are covered is the profit. And as we mentioned earlier, a negative margin indicates the cost of producing the product exceeds its revenue.
Contribution margin analysis is used to compare the cash generated by individual products and services. It helps companies decide whether to add or subtract a product line, how to price a product or service and how to structure sales commissions or bonuses.
Managers then use the analysis to evaluate potential acquisitions and to determine which products should be sold and which should be terminated. Potential investors can use contribution margin analysis to compare the offerings of acquisition targets as part of the due diligence process.
The contribution margin formula
The formula for the unit contribution margin is:
Contribution Margin = Price – Variable Costs
To take the computer chair example above, $120 = $300 – $180.
Another common way to look at contribution margin is as a ratio expressed as a percentage.
The contribution margin ratio is calculated as:
(Revenue – Variable Costs) / Revenue x 100
So again, let’s take the chairs: ($300-$180)/$300 x 100 = 40%. The closer to 100, the more money available for covering fixed costs and adding to profits.
Improving contribution margin
There are several strategies that can improve the contribution margin of any business. Most address decreasing variable costs as reducing fixed costs doesn’t affect the contribution margin:
- Decrease variable labor costs, such as overtime.
- Increase prices. Higher prices mean that there’s more money generated by the sale of each product or service. As long as variable costs don’t increase and sales don’t decrease, the contribution margin will improve.
- Reduce raw material costs. This can be accomplished by purchasing from a cheaper supplier, reducing the amount of money spent on production.
- Reduce shipping and delivery costs.
Contribution margin vs. gross profit margin
The contribution margin and the gross profit margin are both analysis tools used to help businesses increase profits, but they measure different aspects of a business. The former looks at how one product contributes to the company’s profits and the difference between the sales price and variable costs, while the latter looks at overall business profits. The contribution margin excludes fixed costs, whereas the profit margin includes fixed costs. To calculate the gross profit, subtract the cost of goods sold (COGS) from revenue. COGS includes fixed and variable costs.
While contribution margin is an important business metric, how you calculate variable costs influences the number. And, as a pretty granular number, it gives you insight into a specific product’s profitability, but not the overall company’s profits. For a more holistic view, use it with other profitability ratios such as gross profit, operating profit and net profit.