‘I don’t want to earn more revenue’ said no business owner ever. Turning a good profit is the ultimate goal of any venture big or small. But getting that number up requires quite a bit of effort – doing more marketing to expand your customer base, adding new products or services to appeal to a larger demographic, looking for ways to minimize inventory costs, and adding technology to streamline business processes, etc.
But one thing that business owners may fail to do as they look into increasing revenues is to calculate their contribution margin before they do anything else.
What is Contribution Margin?
Contribution margin (also known as dollar contribution per unit) is a handy accounting metric that will help you determine how much of your revenue contributes to the coverage of fixed costs and not being consumed by variable costs.
Sounds puzzling? Let’s figure things out step-by-step.
- Variable costs are those that your business incurs to develop a single product. They are variable because some products are cheaper and faster to produce. For example, it may take more water and coffee beans to make a grand cafe latte versus a modest espresso. Also, it can take more time to make one specific product over another.
- Fixed costs are your rent, salaries, insurance, taxes and other outgoing payments you need to make. Mostly, these remain stable.
Calculating a contribution margin means that you are trying to estimate how much it will cost you to make one unit of one product. The contribution margin formula is as follows:
Contribution margin = revenue from one unit – variable costs
For example, if the variable costs to produce one pair of heeled shoes are $100 and you then sell them for $135, your contribution margin is $35. That is how much that pair of shoes will contribute to your overall revenue.
Remember, the contribution margin is separate from a gross profit margin, because it does not take into account your fixed costs, only those unique costs of producing that one product. Gross profit margin is the amount that is left after all costs of goods sold are taken into account.
Why Does Contribution Margin Matter?
So why should you bother with going so granular with your margins? Isn’t gross profit margin and ultimate net revenue what you should be concerned about? Of course, you should be concerned about these, for they give you the ultimate figures for your balance sheet and a solid understanding of how much your business is making.
But you also need to know the contribution margin of the products or services you are producing and selling, to ensure that they are worth your while to continue to produce.
A prime example of business decisions being made based on contribution margins is the soft drink industry. Over the years, Pepsi, Coca-Cola and the likes pushed a variety of new products to the market, only to discontinue them later on because the contribution margin was poor or even negative. In short, they were losing money on making those drinks, instead of making them.
Unlike some huge conglomerate, you may not have the luxury of getting a bunch of different products to the market just “to see how it goes with the customer”. And if you are not paying attention to your contribution profit margins, you may end up having cash flow issues (but we hope that won’t happen!)
How to Calculate Contribution Margin: Key Tips + Example
As mentioned earlier the simple formula you should use is this: contribution margin = revenue from one unit – variable costs.
But the calculation itself isn’t as straightforward as you might think. To figure out your number, you’ll first have to categorize all your fixed and variable expenses. This can be tough because they often seem to overlap.
Let’s look at three examples of variable expenses:
- You have a fixed expense of a water bill. Usually it’s expressed as an average or a total on an annual balance sheet. But this year, you added a product that required more water to produce than other products. How much did your water bill increase? This will be a variable expense related to the production of that specific product.
- Suppose your sales department works on a commission basis. To push a new product and motivate your sales department to pitch it to customers, you offer a bit higher sales commission for that good. The commissions are a fixed expense, but the additional amount that you pay for sales of this product are a variable expense.
- What new raw materials are you purchasing for a specific product and what are the costs involved for both purchasing and shipping? This is not a fixed business expense but, rather, an expense that you can choose to continue to make or not, dependent on whether the profit from the product, if there is one, is worth it.
Once you have identified the variable costs for a product, you are ready to determine how much one unit costs. To do this, you take the variable costs of producing, say, 100 units and simply divide that by 100. Now you have your unit cost and are ready to use the formula to figure the contribution margin.
Contribution Margin Example
Here is an example: company ABC produces and sells gardening supplies and small equipment. It has decided to add a new product, specifically, a battery-operated edger/trimmer and commissioned an initial production batch of 20,000 units. The variable costs will include:
- the raw materials that must be purchased
- changes that must be made on the production line
- additional utility costs
- and maybe even some overtime for employees to get a faster time-to-market.
- And you have also provided a bonus incentive to salespersons to push the said product.
So a sample contribution margin calculation will be as follows:
Variable costs of 20,000 units = $1,500,000
Variable costs of one unit ($1,500,000 ÷ 20,000 = $75.00)
Now, from this, the company can calculate a break-even point. If they can sell each unit for $75, they will neither earn a profit, nor have a loss. But, if they manage to sell that new trimmer for at least $100 per unit, they’ll get some extras.
Contribution Margin = $100 – $75 = $25.00
What Do You Do Next With that Contribution Margin Figure?
The most important conclusion you can draw from calculating a contribution margin will not come immediately. It will come over time. And it will depend a great deal on how many unit sales you make over a determined amount of time.
If, for example, you have produced 20,000 units and sales are not what you expected, your contribution margin will not change, but your overall revenue will. If you have only sold 2,000 units in a quarter, you are warehousing 18,000 units at a cost. It is inventory that is not moving. And if at the end of a full year you have only sold 8,000 units, you have 12,000 still sitting there unsold.
This new product is not contributing to overall revenue growth. And to get rid of it, you will have to lower the price and hope that you get those remaining 12,000 units sold. Your contribution margin will then be even lower. At the same time, you have other products that are selling well and providing a better contribution margin ratio.
The ultimate use of a contribution margin is to calculate it for each product/service you produce or offer. When you do this, you will know specifically which products are contributing the most to your bottom line, which are being somewhat helpful, and which are really not contributing to revenue growth.
When you have this information, you can make decisions about discontinuing some products and identify those that could benefit from greater marketing efforts, small improvements, etc. The contribution margin of each product or service will also allow you to consider changes in pricing. These are the things that will contribute to greater revenue in the long run!
Photo By Wilfred Iven