As a business owner you’re most likely concerned about how much you’re profiting. You’re probably used to looking at your profit margin, which calculates how much your sales revenue exceeds your cost, but to get a more in-depth idea of how much a specific product is contributing to your profit, you need to calculate the contribution margin.
If you don’t understand what exactly that means, you’re not alone. Many business owners don’t have a firm grasp on the difference between the two terms. Luckily we’re here to help. Here is a breakdown of what contribution margin means, how to calculate it, and why you need it in the first place.
What is contribution margin?
The contribution margin is the revenue that is left over when you deduct the total variable cost of delivering a product or service you made or provided from the selling price. To better understand the concept, think about your income statements. You calculate your gross profit by subtracting the cost of goods sold, then you subtract the operating expenses to get your operating profit, and then you deduct everything else (taxes, interest, etc.) to calculate your net profit.
If you calculate it differently by taking out the variable costs (see below for more details on these), you get the contribution margin, which shows the total revenue that is available to cover fixed expenses and bring profit to the business.
The contribution margin also gives you more insight on whether or not a specific product is generating enough in total sales to contribute to your bottom line.You can also use contribution margin to conduct a break-even analysis (also known as a cost-volume-profit analysis) and determine the number of units needed to reach your break-even point.
What are the elements of contribution margin?
You’ll need to understand fixed and variable costs before you can calculate the contribution margin.
The fixed costs of a business are the ones that stay fairly consistent, such as building rent, salaries, and utilities. They can fluctuate at times, but you can usually count on them to stay the same. Your variable expenses are the costs that are dependent on your production levels. Examples of these kinds of costs include labor, electricity, and raw materials.
How do I calculate contribution margin?
Use this simple equation when calculating total contribution margin (CM):
CM = Price per Product — Variable Cost per Product
You can also take things a step further by dividing the margin by the total number of units to see how much one unit sale brings to your total profit.
The contribution margin ratio shows the percentage of revenue that is profit and fixed expenses. You can calculate it by using this equation:
CM Ratio = (Sales — Variable Expenses) ÷ Sales
Why do I need to know the contribution margin?
Knowing the contribution margin of a product will help you make important decisions such as whether to add or subtract a product line and how to set the sale price of a specific item or service.
Owners and managers also often use the CM to determine which products to keep and which to get rid of. If you have a product with a negative contribution margin, you’re losing money on every single unit you produce. If this is the case, you have two choices: increase the sale price of the product or drop it entirely. If the CM is positive, it’s contributing to your fixed costs and profit and is worth keeping.