As any business owner knows, you have to spend money to make money. The key, of course, is tomake more than you spend. One important way to stay on track is by measuring contributionmargin. Contribution margin is the amount of sales revenue that remains after a company paysfor its variable costs and is to cover its fixed costs. Any amount left after that isprofit. Understanding contribution margin can help businesses determine break-even points,prices for products and services, ways to cut costs — and, ultimately, improve theirbottomlines.
What Is Contribution Margin?
Contribution margin is the difference between a company’s sales revenue and itsvariable costs, which are expenses that vary depending on sales volume, such as salescommissions. Contribution margin is the amount of revenue that a product or service“contributes” toward a business’s fixed costs — expenses, like rent,thatdon’t change relative to sales volume. Also known as dollar contribution per unit,contribution is calculated as a dollar amount and can be converted to a ratio that shows thepercentage of every dollar in sales revenue that equals its contribution margin. The higherthe ratio, the more money there is to cover fixed costs; the opposite is also true, in thatthe lower the ratio, the less money to pay fixed costs.
Key Takeaways
- Contribution margin is a financial metric that shows how well a product is contributingto a business’s profitability.
- Companies use contribution margin, along with other metrics, to make key operational,sourcing, sales and pricing decisions.
- Understanding contribution margin inputs helps businesses optimize their variable costsand, if necessary, tweak or update their sales and pricing strategies.
Contribution Margin Explained
Contribution margin, whether applied to an individual item or a group of products, is afinancial metric that helps companies analyze how well their products and services arecontributing to their overall profitability. Its analysis can help inform a variety ofbusiness decisions. For example, a retailer may be more likely to reorder products with ahigher contribution margin than those with a lower contribution margin. Building on, theretailer could decide to stop carrying the latter product, increase its selling price, seekways to cut its variable costs (more on that soon) and/or initiate a combination of all ofthose options. To gain a bigger picture about performance, businesses may analyzecontribution margin over time, across product lines and in relation to industry benchmarks.
An important distinction worth noting: Contribution margin is different from gross margin,though both measure profitability. Contribution margin is what’s left when variablecosts are deducted from sales revenue, while gross margin is what’s left afterdeducting the cost of goods and services sold(COGS) — that is, the fixed and variable direct costs of creating a product orservice.
Contribution Margin Formula
Contribution margin can be calculated for a product or product line. The formula requires twoinputs: sales revenue and variable costs.
Contribution margin = sales revenue –variable costs
The contribution margin for a bottle of shampoo that retails at $10 and has a variable costper unit of $3 is $7 ($10 – $3). That means the retailer has $7 worth of productrevenue toput toward its fixed costs, after which profit remains.
Contribution margin can also be expressed as a percentage, known as the contribution marginratio. The contribution margin ratio is the contribution margin divided by sales revenue.
Contribution margin ratio = (contributionmargin / sales revenue)
The contribution margin ratio for the bottle of shampoo is 70% [$7 / $10]. That means thatfor every additional item sold, 70% of the product’s revenue is contribution margin,to be allocated toward fixed costs and profit.
Fixed cost vs. variable cost
Costs associated with running a business fall into two main categories: fixed and variable.
- Fixed costs are expenses incurred no matter the company’s levelof production. Whether a company produces one widget or 1 million, set costs, such asrent, insurance, salaries and real estate taxes, will need to be paid every month.
- Variable costs are direct and indirect expenses that fluctuate, basedon the company’s level of production. Examples of variable costs include rawmaterials, sales commissions and shipping charges. Variable costs rise and fall as therate of production increases or decreases.
Then there are costs that contain both fixed and variable elements. These are called mixedcosts, semi-variable costs or semi-fixed costs. For example, a business could have acontract with a mobile carrier for a flat monthly rate that covers 500 users within acertain call and data limit. That is a fixed cost. Anytime a user exceeds the allottedlimit, the company is charged. That is a variable cost. In a manufacturing scenario, fixedcosts stay the same regardless of production level, while variable costs rise or falldepending on the level of activity.
What Contribution Margin Can Tell You
Contribution margin communicates how much or how little a product is contributing to abusiness’s overall profitability and, when tracked over time, can help determinewhether the product is worth continuing to produce or sell. The greater the contributionmargin, the more money the business has on hand to meet its fixed expenses. Conversely, anegative contribution margin means the company is losing money on each sale it makes —andtaking away precious resources from higher-revenue-generating endeavors. If a product is notgenerating enough contribution margin to cover its fixed costs, managers would be welladvised to probe into associated costs to see what could be eroding the contribution margin.
How Companies Use Contribution Margin
One of the most important ways companies use contribution margin is to determine aproduct’s or service’s break-even point, wheretotal fixed and variable expenses match total revenue. In this scenario, all costs arecovered, period. In dollar terms, the break-even point for any given offering is calculatedby subtracting fixed expenses from the contribution margin. In unit terms, the break-evenpoint is calculated by dividing fixed expenses by a single unit’s contribution margin.Only by exceeding the break-even point — from additional sales revenue or greaternumber ofitems sold — can a company realize a profit.
Companies also use contribution margin to:
- Evaluate variable costs to determine where cuts or increased investments can be made.
- Price their products and services to not only offset variable and fixed costs but alsomake a profit, which can then be reinvested back into the business.
- Decide which products to produce or carry more, less or none of.
- Prioritize which products to produce, market or sell, as well as which clients andaccounts to focus on.
- Structure bonuses and sales commissions in accordance with how much salespeople’seffort contributes to the contribution margin.
Contribution Margin Examples
Let’s take the example of a hypothetical e-retailer, Planet Spice, which sells spicesand related accessories. Last month, the business sold 2,000 spice grinders for $25 each.Its variable cost per unit for raw materials, packaging, shipping and labor was $10.Recalling our contribution margin formula — sales revenue – variable costs—the contributionmargin for one spice grinder was $15 ($25 – $10), or $30,000 ($15 x 2,000) for all. Ifthecompany’s fixed costs were $25,000, it had enough contribution margin to cover thosecosts, with $5,000 remaining for profit.
Planet Spice’s CFO decides to take a closer look at the product’s variable costsand determines that the company can trim packaging- and shipping-related expenses by $2.Doing so would increase its contribution margin to $17 per unit ($25 ¬ $8), or $34,000($17x 2,000) for all. After paying its $25,000 worth of fixed expenses, the company would windup with a $9,000 profit.
Using the spice grinder’s original contribution margin, Planet Spice can now calculateits contribution margin ratio by dividing it by the product’s revenue: $15 / $25 =60%. That means, for every dollar of revenue the spice grinder generates, 60 cents isavailable to go toward fixed costs, after which anything left over is profit. To improvethat ratio, the CFO can take another look at the product’s variable costs or reexaminethe business’s fixed costs to determine other possible ways to lower its expenses.
How to Improve Contribution Margin
Along with profit margin, operating margin and other measures ofprofitability, contribution margin is a key financial metricthat guides many important business decisions. For example, let’s say a manufacturerof luxury handbags wants to compare the contribution margin of its handbags made of leatherversus those constructed from synthetic materials. It discovers that the latter has a highercontribution margin. Why aren’t the leather handbags doing as well? A deep dive intoproduct costs uncovers a surge in the price of natural materials. Now the manufacturer has adecision to make: to research other suppliers and, in time, find a less expensive option, orto raise the price of its leather handbags to cover its costs and, in turn, improve itscontribution margin — as long as customers are willing to pay more for them, ofcourse. Ifthe contribution margin begins to trend upward as the result of either option, the companycan stay the course. If it doesn’t, the company could decide to cut back or stopcarrying leather handbags.
Contribution margin can also inform the retailer’s marketing campaign. To help sell itsnow-pricier leather handbags, the retailer could rework its marketing message to play intothe emotional value of owning one rather than, for example, the bag’s high-qualityfeatures.
Other ways businesses can improve their contribution margins — and boost their bottomlines —include using lower-priced packaging materials and turning off its machinery overnight tosave electricity. A business could also reduce product discount percentages, hire fewerexpensive laborers or purchase additional equipment to more quickly produce the same numberof products.
Improvement might also be achieved through process costing, a method often used bymanufacturers to track the cost of each step in an item’s production process. Thisdetailed information can help pinpoint places where costs can be cut. Of note, processcosting is a time-consuming process best left for companies that mass produce large volumesof hom*ogeneous products.
It is generally accepted that a high contribution margin is desirable for a product, but somedecision-makers may determine that a product, while not having a strong contribution margin,nevertheless attracts customers and leads to sales of complementary, higher-margin products.
Using Accounting Software for Contribution Margin Analysis
Calculating contribution margin as part of a company’s financial analysis may appearsimple and straightforward. But manually tracking sales revenue and all the various variablecosts related needed to compute the metric is time-consuming, and it can easily result inmissed costs that skew results. As part of its enterprise resource planning (ERP)platform, NetSuite’s financial managementand cloud accountingsolutions relieve this burden by gathering all financial data needed to accurately calculatecontribution margin. The system classifies every transaction and expense all the way down tothe SKU, or item, level, so the business can understand costs for every specific product. Inaddition, with NetSuite’s role-based dashboards, stakeholders can identify trends,flag issues and make key decisions about whether to offer a product or service, how to priceit and, by drilling down on expenses, ways to possibly cut back and boost profitability.
Tracking contribution margin is a core part of a financial analysis that aims to measure theprofitability of a specific product, service or entire line of either. Contribution marginhelps business leaders make informed decisions about factors like product and servicepricing; whether it should add, scale back or eliminate specific offerings; and ways tocontain costs. The higher the contribution margin for a given item, the more revenue thatwill remain for a business to use to pay its fixed expenses, surpass its break-even pointand, ultimately, realize a profit.
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Contribution Margin FAQs
What is a good contribution margin?
Generally speaking, the higher the contribution margin is, the more the product is able tocontribute to a business’s fixed costs and profit. Otherwise, what constitutes a“good” contribution margin varies according to the type of product or service,its variable costs and the industry it’s part of.
What is the difference between contribution margin and profit margin?
Contribution margin and profit margin are two common profitability metrics. Contributionmargin is the amount of sales revenue that remains for a product or service after itsvariable costs are deducted. That money contributes to paying the company’s fixedcosts; any amount left over is profit. Profit margin is the amount of sales revenue thatremains after total expenses — both variable and fixed —are deducted.
How or why is contribution margin important in business?
Contribution margin is a significant metric for business leaders to determine productperformance and its impact on overall profitability. It can help inform decisions aboutpricing, sales, marketing, materials sourcing and resource allocation.
Is contribution margin the same as profit?
No. Contribution margin is how much product or service revenue is left to pay for fixed costsafter variable costs are deducted. Profit is what remains after fixed costs are paid.
What is contribution margin vs. gross margin?
Contribution margin reflects how much revenue a company has left after it deducts itsvariable costs. The remainder is put toward paying fixed costs. Gross margin reflects howmuch revenue is left less the costs of goods and services (COGS). Both are measures ofprofitability.
