Running a business is a constant juggle, but here’s a really important ingredient to help you identify what is actually profitable in your business — contribution margin.
It sounds like some technical jargon that your accountant may throw at you, but it’s actually quite simple to measure and understand.
Read on for an easy breakdown of contribution margin and what it means, some example calculations, what good looks like, constraints of contribution margin analysis, and how to actively improve your business contribution margin.
What is a contribution margin?
So, what is a contribution margin? It’s defined as:
Revenue – Variable costs = Contribution Margin
Yes, it’s a formula as most accounting based measures are — but it can be kept quite simple. The contribution margin is when you deduct all connected variable costs from your product’s price, which results in the incremental profit earned for each unit. This shows whether your company can cover variable costs with revenue. The contribution margin is normally shown in monetary terms.
Before calculating your contribution margin, you need to be clear about which costs are variable and which ones are fixed. Variable business costs are expenses that change according to the number of a product that is produced — for example, materials or sales commissions. Fixed business costs stay the same, irrespective of the number of products that are produced, such as insurance and property taxes.
What is a contribution margin ratio?
Contribution margin ratio is a ratio showing the contribution margin in terms of a percentage of the price. It is defined as:
It’s helpful to look at the ratio as well as the margin when analyzing different products across your business. This will enable important operational decisions about how to improve the profitability of product lines, invest more into your high performing contribution margin items and those to discontinue.
Working example: Contribution margins in a café
To explore this further, let’s use an example of your local cafe trying to measure the contribution margin of a cup of coffee for the month of March.
The Revenue is the sales made from all coffees sold in March which is $10,000.
Variable costs are all the direct costs that contribute to producing that delicious cup of coffee for the customer. This may include items such as coffee beans, water, milk, disposable cups, and labor costs which total $4,000.
In this example, the contribution margin is $10,000 - $4,000 = $6,000. The contribution margin ratio shows a margin of 60% ($6,000/$10,000).
That sounds like a good result. But this same café also sells muffins.
The Revenue from all muffins sold in March is $6,000. Variable costs total $1,000. The contribution margin is $6,000 - $1,000 = $5,000. The contribution margin ratio shows a margin of 83% ($5,000/$6,000).
This café owner has a higher contribution margin from selling coffees but the muffin sales are much more profitable (83% vs 60%). Both product lines are delivering value for the café with relatively high margins, but higher profits could be achieved if the café focused on selling a higher number of muffins.
So, what does good look like?
It will depend on your industry and product line as to what is deemed a satisfactory or good contribution margin. However, the closer the contribution margin is to 100%, the more funds are available to cover the fixed costs of the business and deliver a higher profit.
Products with a low or negative contribution margin should likely be discontinued, but there are circumstances where analysis beyond this metric should be reviewed further.
Constraints of contribution margin analysis
One challenge that may not be highlighted by using this financial analysis is how much resource is required to produce the product. Normally you will want your product to have a contribution margin as high as possible. However a low contribution margin product may be deemed as a sufficient outcome if it uses very little resources of the company to produce and is a high volume sale product.
How to actively improve your business contribution margin
To improve the business contribution margin, the business has a range of options that include price increases, operational efficiencies, reducing cost or negotiating supplier discounts.
A price change is an easy way to improve the margin but the business needs to evaluate whether the customer is willing to pay more for the product.
Operational efficiencies require a real focus on understanding all of the elements that go into producing the product and how to make improvements. This could be through technology, increasing capacity or purchasing more productive equipment.
Reducing cost can be the most difficult option as it will most likely mean labor reduction or negotiating to spend less with your suppliers.
Profitability starts here
Contribution Margin is an important element of understanding the profitability of the products in your business. Whether you use the services of a professional accountant or choose to use an online calculator to work out your company’s contribution margin ratio, it’s important to have an understanding of how to calculate this valuable financial metric.
An associated complexity of understanding how to calculate your contribution margin ratio is properly allocating fixed and variable costs.