To run a business successfully, you need to know everything about your business, including its finances. One of the most critical financial metrics to understand is contribution margin, which can help you determine how much money you’ll make selling specific products or services.

More importantly, your company’s contribution margin can tell you how much profit potential a product has after accounting for specific costs.

Below is a detailed breakdown of contribution margins, including how to calculate them.

What is Contribution Margin?

A contribution margin represents the money earned by selling a product or unit after deducting the variable costs of running your business.

Consider the name – contribution margin is how much the sale of a particular product or service contributes to the overall profitability of your business. It is how valuable the sale of a specific product or product line is.

Related: How to price your staffing services

In a contribution margin calculation, you determine the selling price per unit (such as the selling price for a car) and then subtract the variable cost per unit or the variable cost of making each product.

You may need to use the contribution margin formula for your company’s net income statements, net sales or net profit statements, gross margin, cash flow, and other financial statements or financial ratios.

What does a contribution margin tell you?

The contribution margin is one of the critical parts of a break-even analysis. A break-even analysis is a financial calculation in which the cost of production is weighed against the unit selling price to determine the break-even point, the point at which total cost and total revenue are equal. Break-even analysis can help you with risk management

Break-even analyzes are useful for determining how much capital you need for a new product and for calculating the amount of risk associated with new business ventures. They are often used to determine production costs and sales price plans for various products, such as:

• How much you should price specific products.
• How many products you need to sell to make a profit (the number of units can determine whether you have a low contribution margin or a high contribution margin).
• How much product revenue you will generate.

Contribution margin further tells you how to separate total fixed costs and profit elements or components from product sales. In addition, contribution margins help you determine the selling price range for a product or the possible prices at which you can sensibly sell that product.

Other things the unit contribution margin tells you include:

• Profit levels you should expect from selling specific products.
• Sales commission structures that you must pay to the members of the sales team.
• Sales commission structures that you must pay to agents or distributors.

How do you calculate a contribution margin

Fortunately, you can calculate a contribution margin with a basic formula:

C = R – V

“C” stands for contribution margin. “R” stands for total revenue and “V” stands for variable costs. With these definitions, the equation goes like this:

Contribution margin = the total turnover – variable cost

Keep in mind that you can also express your contribution margin in terms of a fraction of your company’s total turnover. The contribution margin ratio or CR would then be expressed using the following formula:

CR = (R – V) / R or contribution margin = (the total turnover – variable cost) / the total turnover

Fixed costs against variable cost

Crucial to understanding contribution margin are fixed costs and variable costs.

Fixed costs are one-time purchases for things like machinery, equipment, or business real estate.

Fixed costs usually stay the same no matter how many units you make or sell. The fixed cost for a contribution margin equation becomes a smaller percentage of the cost of each unit as you make or sell more of those units.

Variable costs are the opposite. These may fluctuate from time to time, such as the cost of electricity or certain supplies depending on the status of the supply chain.

Contribution margin example

Imagine you have a machine that makes new cups and it costs $20,000. To make a new cup you have to spend $2 for the raw materials, such as ceramics, and electricity to power the machine and labor to make each product.

If you were to make 100 new cups, your total variable cost would be $200. However, you have to remember that you also need the $20,000 machine to make all those cups. The machine represents your fixed costs.

Now imagine letting those cups sell for three dollars each. You can now determine the profit per unit by plugging in the figures above:

• SP – TC = Profit per unit, where SP is the selling price and TC is the total cost.
• $3 – $2 = $1 profit per unit.

In this example, the profit per unit equals the contribution margin. It’s how much each cup sale contributes to “real” profit.

How can you use contribution margin?

You can use contribution margin to help you make intelligent business decisions, especially regarding the types of products you make and how you price those products.

Contribution margin analysis can help your company choose from a variety of products it can use to compete in a specific niche based on available resources and labor.

Related: Your determine Break even point

For example, you can create a more expensive version of a generic product if you think it will make better use of your limited resources given your fixed and variable costs.

You can also use contribution margin to tell you if you’ve accurately priced a product against your profit goals.

For example, if the contribution margin for a specific product is too low, that could be a sign that you need to raise the price as you sell the product. It may also indicate that you need to reduce the variable (i.e. production and supply related) costs associated with that product in order to increase your profit.

Contribution margin as compared to gross profit margin

Contribution margins are often compared to gross profit margins, but they differ. Gross profit margin is the difference between your sales revenue and the cost of goods sold.

When calculating the contribution margin, you only include the variable costs that are required to make a product. Gross profit margin includes all the costs you incur to make a sale, including both variable costs and fixed costs, such as the cost of machinery or equipment.

Related: How to Calculate Gross Profit

In addition, a contribution margin tells you how much additional income you will earn by creating additional units after reaching your breakeven point.

Simply put, a contribution margin tells you how much money each additional sale adds to your total profit after reaching a specific point of profitability.

This is one of the reasons economies of scale are so popular and effective; at some point, even expensive products can become profitable if you make and sell enough.

When to use contribution margin?

In general, you should use contribution margin to tell you:

• If you mispriced a product.
• How many products you have to sell to make a profit based on variable costs.
• Whether you need to reduce operating or labor costs of making a product.

A negative contribution margin usually indicates negative performance for a product or service, while a positive contribution margin indicates the opposite.

However, it may be best to avoid using just a contribution margin, especially if you want to evaluate the financial health of your entire company. Instead, consider using contribution margin as part of a comprehensive financial analysis.

Use contribution margin in addition to gross profit margin, your balance sheet, and other financial statistics and analytics. This is the only real way to determine whether your business is profitable in the short and long term, and whether you need to make large-scale changes to your profit models.

Related: Understand the difference between Gross profit margin and formatting

As an investor, you can also use the contribution margin. Investors and analysts use contribution margins for a company’s major or primary products.

They can use that information to determine whether the company is accurately pricing its products or is likely to make a profit without looking at that company’s balance sheet or other financial information.

For example, if a company has a low contribution margin for its essential products, it may spend more money than it takes in.

Conversely, a good contribution margin can indicate that the company is an excellent operation and uses its resources wisely.

Related: The 5 myths of mastering Profit margins

So, what are the takeaways about contribution margins?

As you can see, contribution margin is an important metric to calculate and keep in mind when determining whether to make or provide a specific product or service.

Once you’ve calculated your contribution margin, you can determine whether one product or the other is ultimately better for your bottom line. Still, of course, this is just one of the critical financial metrics you need to master as a business owner.

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