The contribution margin of a business is also sometimes called the gross margin. The contribution margin formula enables a business to calculate how much liquidity remains in the business as a result of sales when all variable expenses involved in manufacturing a product have been taken into account. Once the contribution margin has been calculated, subtracting fixed expenses such as wages, plant costs and rent will produce the net income, also known as the profit.
The contribution margin formula
It’s possible to work out the contribution margin of a business by using the following formula:
Revenue generated by the product minus the product variable costs divided by the revenue generated by the product
For example, if a business has generated $500,000 through product sales, and the variable costs of these sales were $200,000, then the contribution margin formula will be as follows:
500,000 minus 200,000 divided by 500,000, which equals 0.60 or 60%
How much should a contribution margin be?
In simple terms, the higher the contribution margin is to 100%, the better it is, because this means there is more money available for the business to be able to cover its overhead expenses, also known as fixed costs. In most cases, however, the contribution margin of a business is likely to be less than 100% and usually will actually be below 50%.
How can the contribution margin be used?
The contribution margin presents a picture of how profitable the business as a whole is, but is even more useful in terms of measuring the profitability of a specific product. Once the contribution margin for a specific product has been calculated it is easier for the people running the business to decide whether selling the product at its current price makes sense as a business decision. If the contribution margin is particularly low, the likelihood is that this product isn’t creating enough profit to be viable. If so then it may make sense to drop particular product lines in order to lift the contribution margin of the whole company.
Making choices based on the contribution margin
The contribution margin is also a useful metric to use when comparing a range of different products that lay claim to the same set of manufacturing resources. If a factory produces a range of speakers, for example, and uses the same production line to complete high quality speaker pairs as it does to manufacture single portable speakers, then a contribution margin calculation could ascertain which of the speakers represents the future of the company.
If the calculation reveals, for example, that the single portable speakers have a higher contribution margin than the high quality speaker pairs, then this means they offer a greater potential for profitability. In these circumstances, the business may decide to switch the emphasis of the production away from the high quality speakers and concentrate on the potentially more profitable single speakers.
A contribution margin calculation of this kind is common practice across businesses that have a diverse product range and are constantly working to make sure that resources are being allocated and utilised in the way that is most likely to maximise profits.
We can help
Knowing the contribution margin of a specific product will enable you to drive the profits of your business higher. You can boost those profits further by partnering with a payment platform like GoCardless to simplify the more complex aspects such as dealing with ad hoc payments or recurring payments and cut overheads across the board.