What is Contribution Margin?
If business were a game show, then net profit would be the grand prize we slog our bums for. And much like in one, fortunately, we have multiple lifelines that help us through. Kind of like our metric in the spotlight today - Contribution Margin.
Before we move on to define it, let’s understand that there are two types of costs:
- Variable Cost - Costs that move up or down with the number of units sold such as the cost of inventory, electricity, direct labor, etc.
- Fixed Cost - Costs that remain constant regardless of the number of units sold such as rent, subscriptions, salaries, etc.
If we deduct all variable costs from revenue, we’d get an amount that can be used to cover all the fixed costs. This is the contribution margin.
And from the contribution margin, if we remove all fixed costs, we land on net profit. Ka-ching!
How to calculate contribution margin?
Contribution margin is the difference between the sales price of a product and the variable costs associated with its production and sales.
Contribution Margin = Sales Revenue - Variable Costs
Say you sell a product unit for $10. You pay transportation and labor costs of $6. Then the amount you are left with (10-6) $4 is the contribution margin. Some part of it will be spent covering the fixed costs (say the rent of your office) and if you are lucky, you’ll have some amount left to pocket as your net profit.
The absolute numbers are huge if we consider the whole inventory. This is why everyone generally uses the contribution margin ratio to get a per-unit idea.
Contribution Margin Ratio = (Sales Revenue - Variable Costs) / Sales Revenue
For example, if you earned $200,000 on goods with a variable cost of $100,000 associated with them, then your contribution margin ratio would be:
(200,000 - 100,000)/200,000 = 0.5 or 50%
How can you use contribution margin to make decisions?
Much like all profitability ratios, the higher the contribution margin ratio, the better. A 90% ratio would mean that after taking account of all variable expenses in your sales revenue, you have 90% of the revenue amount left to cover your fixed costs.
This ratio can help you in making multiple strategic decisions by letting you know how profitable a particular product line is. It can help you infer whether it makes sense for you to continue selling the product at the current price or not.
A very low margin would indicate that perhaps it is time to call quits on a particular product while a high margin would indicate that it is profitable to market that product more than others.
This margin is especially useful when the resources are limited and have to be distributed among a few lines of product. Based on the ratio, you can allocate available resources most efficiently to products with the highest profit potential.
How to improve the contribution margin?
There are only two ways of improving contribution margin: either reduce the variable costs or increase the price of the product.
Both are not as easy as they sound on paper. This is perhaps why being aware of contribution margin and improving it should be nothing short of a constant endeavour.