What Is the Contribution Margin & How to Calculate It? A Guide
As an owner of a business, it’s important to understand how profitable the business is.
There are a number of different metrics people use to measure a business’s profitability. Many people will look at something such as your profit margin. This measures the total amount by which your revenue from sales exceeds your overhead costs.
However, if you want to understand how a specific product contributes to your profit, you’ll need to take a look at the contribution margin.
But what exactly is the contribution margin? We’ll take a closer look at the definition and give you the tools to calculate it.
Here’s What We’ll Cover:
What Is the Contribution Margin?
The contribution margin is a business’s sales revenue minus its variable costs. So when you make a product or deliver a service and deduct the variable cost of delivering the product, whatever revenue is leftover is the contribution margin.
The contribution margin can be presented as:
- The total amount
- The amount for each product line
- The amount per unit of product
- As a ratio
- As a percentage of net sales
The measure indicates how a certain product or service contributes to the overall profit of the company. It allows you to figure out the profit potential of a particular profit. It shows the portion of sales that are needed to help cover the business’s fixed costs.
What Is the Formula For the Contribution Margin?
The formula that is used to calculate the contribution margin is simple and straightforward:
Contribution Margin=Revenue-Variable Costs
What Is an Example of the Contribution Margin?
So for example, let’s say that you’re running a small bakery business.
You charge $15 for a red velvet cake and the unit variable cost is $4. You would then use the above formula to figure out the contribution margin:
This would mean that the unit contribution margin is $11.
When approaching the calculation, you first have to take your income statement and re categorise all costs as either fixed or variable. While this may seem like a simple task, it can actually be quite difficult as it’s not always clear which costs fall into each category.
What Are Fixed Costs?
Fixed costs are business costs that stay the same, no matter how many of your products or services you end up producing. Fixed costs are independent of the business operations and cannot be avoided.
Examples of fixed costs may include:
- Depreciation: The lowering of acquisition costs for property, plant and equipment. This is measured by its spread throughout its life span whilst still being in use.
- Interest Expense: This may be the interest rate on a loan that needs to be paid on a regular basis.
- Insurance: Any premium that is paid under an insurance contract.
- Rent: The regular payment for leasing a property.
- Property Taxes: The tax charged by the government. This is based on the assembled value of the property.
- Salaries: The fixed amounts that a business pays its employees for their services. This differs from per hour contracts as it doesn't change month to month.
- Fixed Utilities: The cost of water, gas, electricity etc.
What Are Variable Costs?
Variable costs are variable expenses that vary with the quantity of product that you produce. They are direct and indirect expenses that are incurred by a business from producing and selling various goods and services.
Examples of variable costs may include:
- Direct Materials: These would be the raw materials that are used in producing the actual product.
- Production Supplies: This includes items such as oil and lubricants. Essentially anything that is used to maintain production machines.
- Labour Per Unit: The amount paid to workers per unit completed.
- Billable Wages: The amount paid to workers based on the hours worked.
- Commissions: The amount a company will pay a salesperson for each unit they sell.
- Variable Utilities: The use of electricity and water when producing volumes of goods and services.
Why Is the Contribution Margin Important?
Being able to calculate and analyse your business’s contribution margin helps you to make several types of important decisions. This could be from whether to add or remove a particular product line, or how to price a product or service. It could also help you figure out how to structure sales commissions.
However, the most common use of the contribution margin is to compare products. This is then used to determine which ones should be kept and which ones should be dispensed with.
So if after a contribution margin analysis, a company can see that a particular product or service has a margin of $15. Whereas another product has a negative margin. This makes it very clear which product to keep and which to get rid of.
If a product has a negative margin, then each time the product is being produced the company is losing money. This means it should either stop producing that particular product or increase the selling price.
Being able to understand and calculate the contribution margin of your products is vital. Especially to the financial success of your business.
You can easily identify and take steps towards fixing poor performing products. As well as identifying your best earning individual products.
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