Understanding the profitability of your business is key for anyone running a company. While there are many different profitability metrics to explore – from gross profit margin to net profit margin – contribution margin can help you understand the effect of a specific product on your company’s profitability. But what is contribution margin? Find out more about this common financial analysis tool with our handy guide.
What is contribution margin?
Contribution margin is the amount by which your business’s sales revenue exceeds your variable costs. It’s just another way of looking at profit. Put simply, whenever you deliver a service or product and deduct the variable cost associated with delivering that product, the revenue you’re left with is the contribution margin. In other words, it’s an analysis of the amount that your sales contribute towards fixed costs and profits.
Why does the contribution margin formula tell you?
The contribution margin has a range of different uses, but most importantly, it’s a great way to decide whether to reduce prices for specific products. If the contribution margin at a certain price-point is too low (or even negative), it’s probably not the best idea to continue selling the product at that price, whereas a high contribution margin could indicate that you’re on the right track.
In addition, the contribution margin ratio formula can help you determine how profitable different sales levels are likely to be. This is especially useful if you sell several products that require a common bottleneck resource, as you can focus on the product with the highest contribution margin, and therefore maximize your potential profits.
Furthermore, contribution margin is an important part of break-even analysis. This is because contribution margin can be used to separate fixed costs and profit from product sales, as well as to determine the optimum price range and profit levels for a specific product, while also providing you with the information you need to structure commissions for your sales team.
How to calculate contribution margin
The contribution margin formula is a relatively simple calculation:
Contribution margin = Revenue – Variable Costs
However, you can also work out contribution margin as a percentage of sales. To do that, here’s the contribution margin ratio formula:
Contribution Margin Ratio = Revenue – Variable Costs / Revenue
For example, let’s look at how this might work in practice with a sporting goods company. Imagine that a basketball costs $20, with variable costs per unit of $8. So, to find the contribution margin ratio, we can use the following formula:
20 – 8 / 20 = 0.6
What does that mean? Essentially, it indicates that for this company, the contribution margin for every $1 of revenue is 60 cents.
Now, let’s look at another example. Imagine the same company sold around $50,000 worth of basketballs within a given period, with variable costs of $20,000. However, the company also has fixed costs of $40,000. We can use the contribution margin formula to find out what this means for their bottom line:
50,000 – 20,000 = 30,000
While the contribution margin is $30,000, the business’s fixed costs (premises, staffing, insurance, etc.) mean that the company is making a net loss of $10,000. As a result, they need to decrease their fixed expenses or boost prices if they want to remain solvent and stay afloat.
Contribution margin vs. gross margin
It’s also important to understand the difference between the gross margin and the contribution margin. Put simply, gross margin measures the amount of revenue that’s left after you subtract all the costs that are directly linked to production. So, when it comes to contribution margin vs. gross margin, what’s the difference? Well, while contribution margin provides you with a per-item profitability metric, gross margin offers a total profit metric.
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