As any business owner knows, you have to spend money to make money. The key, of course, is to make more than you spend. One important way to stay on track is by measuring contribution margin. Contribution margin is the amount of sales revenue that remains after a company pays for its variable costs and is to cover its fixed costs. Any amount left after that is profit. Understanding contribution margin can help businesses determine break-even points, prices for products and services, ways to cut costs — and, ultimately, improve their bottom lines.
What Is Contribution Margin?
Contribution margin is the difference between a company’s sales revenue and its variable costs, which are expenses that vary depending on sales volume, such as sales commissions. Contribution margin is the amount of revenue that a product or service “contributes” toward a business’s fixed costs — expenses, like rent, that don’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 the percentage of every dollar in sales revenue that equals its contribution margin. The higher the ratio, the more money there is to cover fixed costs; the opposite is also true, in that the lower the ratio, the less money to pay fixed costs.
- Contribution margin is a financial metric that shows how well a product is contributing to 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 costs and, 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 a financial metric that helps companies analyze how well their products and services are contributing to their overall profitability. Its analysis can help inform a variety of business decisions. For example, a retailer may be more likely to reorder products with a higher contribution margin than those with a lower contribution margin. Building on, the retailer could decide to stop carrying the latter product, increase its selling price, seek ways to cut its variable costs (more on that soon) and/or initiate a combination of all of those options. To gain a bigger picture about performance, businesses may analyze contribution 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 variable costs are deducted from sales revenue, while gross margin is what’s left after deducting the cost of goods and services sold (COGS) — that is, the fixed and variable direct costs of creating a product or service.
Contribution Margin Formula
Contribution margin can be calculated for a product or product line. The formula requires two inputs: 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 cost per unit of $3 is $7 ($10 – $3). That means the retailer has $7 worth of product revenue to put toward its fixed costs, after which profit remains.
Contribution margin can also be expressed as a percentage, known as the contribution margin ratio. The contribution margin ratio is the contribution margin divided by sales revenue.
Contribution margin ratio = (contribution margin / sales revenue)
The contribution margin ratio for the bottle of shampoo is 70% [$7 / $10]. That means that for 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 level of production. Whether a company produces one widget or 1 million, set costs, such as rent, insurance, salaries and real estate taxes, will need to be paid every month.
- Variable costs are direct and indirect expenses that fluctuate, based on the company’s level of production. Examples of variable costs include raw materials, sales commissions and shipping charges. Variable costs rise and fall as the rate of production increases or decreases.
Then there are costs that contain both fixed and variable elements. These are called mixed costs, semi-variable costs or semi-fixed costs. For example, a business could have a contract with a mobile carrier for a flat monthly rate that covers 500 users within a certain call and data limit. That is a fixed cost. Anytime a user exceeds the allotted limit, the company is charged. That is a variable cost. In a manufacturing scenario, fixed costs stay the same regardless of production level, while variable costs rise or fall depending on the level of activity.
What Contribution Margin Can Tell You
Contribution margin communicates how much or how little a product is contributing to a business’s overall profitability and, when tracked over time, can help determine whether the product is worth continuing to produce or sell. The greater the contribution margin, the more money the business has on hand to meet its fixed expenses. Conversely, a negative contribution margin means the company is losing money on each sale it makes — and taking away precious resources from higher-revenue-generating endeavors. If a product is not generating enough contribution margin to cover its fixed costs, managers would be well advised 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 a product’s or service’s break-even point, where total fixed and variable expenses match total revenue. In this scenario, all costs are covered, period. In dollar terms, the break-even point for any given offering is calculated by subtracting fixed expenses from the contribution margin. In unit terms, the break-even point 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 greater number of items 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 also make 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 and accounts to focus on.
- Structure bonuses and sales commissions in accordance with how much salespeople’s effort contributes to the contribution margin.
Contribution Margin Examples
Let’s take the example of a hypothetical e-retailer, Planet Spice, which sells spices and 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 contribution margin for one spice grinder was $15 ($25 – $10), or $30,000 ($15 x 2,000) for all. If the company’s fixed costs were $25,000, it had enough contribution margin to cover those costs, with $5,000 remaining for profit.
Planet Spice’s CFO decides to take a closer look at the product’s variable costs and 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 ($17 x 2,000) for all. After paying its $25,000 worth of fixed expenses, the company would wind up with a $9,000 profit.
Using the spice grinder’s original contribution margin, Planet Spice can now calculate its 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 is available to go toward fixed costs, after which anything left over is profit. To improve that ratio, the CFO can take another look at the product’s variable costs or reexamine the 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 of profitability, contribution margin is a key financial metric that guides many important business decisions. For example, let’s say a manufacturer of luxury handbags wants to compare the contribution margin of its handbags made of leather versus those constructed from synthetic materials. It discovers that the latter has a higher contribution margin. Why aren’t the leather handbags doing as well? A deep dive into product costs uncovers a surge in the price of natural materials. Now the manufacturer has a decision to make: to research other suppliers and, in time, find a less expensive option, or to raise the price of its leather handbags to cover its costs and, in turn, improve its contribution margin — as long as customers are willing to pay more for them, of course. If the contribution margin begins to trend upward as the result of either option, the company can stay the course. If it doesn’t, the company could decide to cut back or stop carrying leather handbags.
Contribution margin can also inform the retailer’s marketing campaign. To help sell its now-pricier leather handbags, the retailer could rework its marketing message to play into the emotional value of owning one rather than, for example, the bag’s high-quality features.
Other ways businesses can improve their contribution margins — and boost their bottom lines — include using lower-priced packaging materials and turning off its machinery overnight to save electricity. A business could also reduce product discount percentages, hire fewer expensive laborers or purchase additional equipment to more quickly produce the same number of products.
Improvement might also be achieved through process costing, a method often used by manufacturers to track the cost of each step in an item’s production process. This detailed information can help pinpoint places where costs can be cut. Of note, process costing is a time-consuming process best left for companies that mass produce large volumes of homogeneous products.
It is generally accepted that a high contribution margin is desirable for a product, but some decision-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 appear simple and straightforward. But manually tracking sales revenue and all the various variable costs related needed to compute the metric is time-consuming, and it can easily result in missed costs that skew results. As part of its enterprise resource planning (ERP) platform, NetSuite’s financial management and cloud accounting solutions relieve this burden by gathering all financial data needed to accurately calculate contribution margin. The system classifies every transaction and expense all the way down to the SKU, or item, level, so the business can understand costs for every specific product. In addition, 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 price it 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 the profitability of a specific product, service or entire line of either. Contribution margin helps business leaders make informed decisions about factors like product and service pricing; whether it should add, scale back or eliminate specific offerings; and ways to contain costs. The higher the contribution margin for a given item, the more revenue that will remain for a business to use to pay its fixed expenses, surpass its break-even point and, ultimately, realize a profit.
Contribution Margin FAQs
What is a good contribution margin?
Generally speaking, the higher the contribution margin is, the more the product is able to contribute 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. Contribution margin is the amount of sales revenue that remains for a product or service after its variable costs are deducted. That money contributes to paying the company’s fixed costs; any amount left over is profit. Profit margin is the amount of sales revenue that remains 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 product performance and its impact on overall profitability. It can help inform decisions about pricing, 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 costs after 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 its variable costs. The remainder is put toward paying fixed costs. Gross margin reflects how much revenue is left less the costs of goods and services (COGS). Both are measures of profitability.