Summary. To understand how profitable a business is, many leaders look at profit margin, which measures the total amount by which revenue from sales exceeds costs. But if you want to understand how a specific product contributes to the company’s profit, you need to look at contribution margin, which is the leftover revenue when you deduct the variable cost of delivering a product from the cost of making it. To calculate this figure, you start by looking at a traditional income statement and recategorizing all costs as fixed or variable. This is not as straightforward as it sounds, because it’s not always clear which costs fall into each category. And this is where most managers get tripped up. But going through this exercise will give you valuable information. Analyzing the contribution margin helps managers make several types of decisions, from whether to add or subtract a product line to how to price a product or service to how to structure sales commissions. But never look at contribution margin in a vacuum. Before making any major business decision, you should look at other profit measures as well.
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When you run a company, it’s obviously important to understand how profitable the business is. Many leaders look at profit margin, which measures the total amount by which revenue from sales exceeds costs. But if you want to understand how a specific product contributes to the company’s profit, you need to look at contribution margin.
To understand more about how contribution margin works, I talked with Joe Knight, author ofHBR Tools: Business Valuation and cofounder and owner ofbusiness-literacy.com, who says “it’s a common financial analysis tool that’s not very well understood by managers.”
What Is Contribution Margin?
Knight warns that it’s “a term that can be interpreted and used in many ways,” but the standard definition is this: When you make a product or deliver a service and deduct the variable cost of delivering that product, the leftover revenue is the contribution margin.
It’s a different way of looking at profit, Knight explains. Think about how company income statements usually work: You start with revenue, subtract cost of goods sold (COGS) to get gross profit, subtract operating expenses to get operating profit, and then subtract taxes, interest, and everything else to get net profit. But, Knight explains, if you do the calculation differently, taking out the variable costs (more on how to do that below), you’d get the contribution margin. “Contribution margin shows you the aggregate amount of revenue available after variable costs to cover fixed expenses and provide profit to the company,” Knight says. You might think of this as the portion of sales that helps to offset fixed costs.
How do you calculate it?
It’s a simple calculation:
Contribution margin = revenue− variable costs
(Video) Contribution Margin explained
For example, if the price of your product is $20 and the unit variable cost is $4, then the unit contribution margin is $16.
The first step in doing the calculation is to take a traditional income statement and recategorize all costs as fixed or variable. This is not as straightforward as it sounds, because it’s not always clear which costs fall into each category.
As a reminder, fixed costs are business costs that remain the same, no matter how many of your product or services you produce— for example, rent and administrative salaries. Variable costs are those expenses that vary with the quantity of product you produce, such as direct materials or sales commissions. Some people assume variable costs are the same as COGS, but they’re not. (When you subtract COGS from revenue you get gross profit, which, of course, isn’t the same as contribution margin.) In fact, COGS includes both variable and fixed costs. Knight points to a client of his that manufactures automation equipment to make airbag machines. For this client, factory costs, utility costs, equipment in production, and labor are all included in COGS, and all are fixed costs, not variable.
“Some parts of operating expenses, which we assume are fixed, are in fact variable,” he says. “The costs of running the IT, finance, and accounting groups are all fixed, but, for example, the sales force may be compensated with commissions, which would then be considered variable.”
Doing this calculation right takes “a tremendous amount of work, and it is critical that you are consistent in your breakdown of fixed and variable costs over time,” Knight says, but the information you gain from looking at profitability at the product level is often worth the effort.
How Do Companies Use It?
Analyzing the contribution margin helps managers make several types of decisions, from whether to add or subtract a product line to how to price a product or service to how to structure sales commissions. The most common use is to compare products and determine which to keep and which to get rid of. If a product’s contribution margin is negative, the company is losing money with each unit it produces, and it should either drop the product or increase prices. If a product has a positive contribution margin, it’s probably worth keeping. According to Knight, this is true even if the product’s “conventionally calculated profit is negative,” because “if the product has a positive contribution margin, it contributes to fixed costs and profit.”
“Some companies spend a lot of time figuring out the contribution margin,” he says. It requires that a managerial accountant dedicate time to carefully breaking out fixed and variable costs. For firms like GE, there is a big focus on looking at products “through a contribution margin lens.” This is important to the company because GE is “a disciplined firm that works in very competitive industries and wants to cut out nonproductive products.” Soit prunes the ones that don’t have a high contribution margin.
It’s likely thata division leader at GE is managing a portfolio of 70-plus products and has to constantly recalculate where to allocate resources. “As a division head, if I have to cut, I’m going to cut products that have the lowest contribution margin so that I can focus resources on growing the business and increasing profit,” Knight says.
Of course, GE has a lot of resources to dedicate to this analysis. But it’s not just the GEs of the worldthat should be considering this figure, Knight says: “Every company should be looking at contribution margin. It’s a critical view on profit, in large part because it forces you to understand your business’s cost structure.”
What Mistakes Do People Make?
Knight says that there are “so many ways you can make a mistake,” all of which stem from the fact that “costs don’t fall neatly into fixed and variable buckets.” He warns that there are some costs that are “quasi-variable.” For example, you might add an additional machine to the production process to increase output temporarily. This falls in between the two categories, since it could be considered an additional cost due to the higher production (and therefore variable), or it could be thought of as a fixed cost since it’s a one-time purchase that doesn’t fluctuate with the amount of product you’re producing. Sometimes certain salaries could be looked at this way as well. “The financial analyst makes a distinction that requires a judgment call on where to classify these salaries,” Knight says. R&D expenses are also subject to scrutiny. “They are sometimes considered fixed costs, while others look at them as direct costs associated with the product. Your contribution margin could be dramatically differentbecause ofhow these costs are categorized.”
Another mistake that some managers make is to assume that you should cut the lowest-contribution-margin products. But youshouldn’tuse contribution margin, or any measure of profit, exclusively; you should consider the fixed cost allocation as well. Take a company’s cash cows, a term coined by the Boston Consulting Group to describe products that provide a steady income or profit. Generally these products require very little support; you don’t have to invest in sales or do any R&D support. And yet cash cows generally show up as having a low contribution margin because they can have high variable costs while not drawing on the company’s fixed costs. However, you wouldn’t necessarily want to cut them as a result; “you have to consider the cost of supporting a product” and “how much of the company’s fixed costsis associated with the product,” Knight explains. “When you find that these low-contribution-margin products fill a product line or are a barrier to entry for a competitor, you should probably consider keeping the product around.”
Looking at contribution margin in a vacuum is only going to give you so much information. Before making any major business decision, you should look at other profit measures as well.
FAQs
What is contribution margin and how is it calculated? ›
The contribution margin is calculated by subtracting the total variable costs from the total sales revenue. The formula is: Contribution Margin = Total Sales Revenue – Total Variable Costs.
Why do we calculate contribution margin? ›A contribution margin measures how profitable a product is to produce. A company's contribution margin shows how much revenue is available after it deducts variable costs like raw materials and transportation expenses.
What is an example of a contribution margin? ›Here's an example of how to solve for contribution margin: If a product sells for $100 and its variable cost is $35, then the product's contribution margin is $65. To generate this as a contribution margin ratio, simply take the contribution margin and divide it by the net sales.
What is the contribution margin ratio answer? ›The contribution margin ratio is the difference between a company's sales and variable expenses, expressed as a percentage. The total margin generated by an entity represents the total earnings available to pay for fixed expenses and generate a profit.
How do you calculate the margin? ›To calculate profit margin, start with your gross profit, which is the difference between revenue and COGS. Then, find the percentage of the revenue that is the gross profit. To find this, divide your gross profit by revenue. Multiply the total by 100 and voila—you have your margin percentage.
What is the contribution margin quizlet? ›Contribution margin is defined as: Sales revenue minus variable expenses. If sales revenue doubles, variable costs will. increase in total.
What is the formula for contribution margin in break even point? ›Contribution Margin = Revenue - Variable Costs
A business breaks even when contribution margin dollars equal fixed costs dollars. Your profit starts when contribution margin dollars exceed fixed cost dollars.
The contribution margin income statement is used for analysis and decision- making. • The contribution margin income statement separates expenses by behavior, emphasizing the distinction between expenses that change when the level of. activity changes and those that are unaffected by it.
What is a contribution margin of 50%? ›The closer a contribution margin percent, or ratio, is to 100%, the more profitable the product or line of business is. This means that the company has covered all costs associated with the product, including both the variable and fixed costs. A contribution margin ratio of 50% or more is considered good.
What does 100% contribution margin mean? ›The closer a contribution margin is to 100%, the better. It means that the business has more money available to cover its expenses. In addition to calculating the contribution margin ratio at an overall level, you should also calculate it for specific products.
How do you calculate margin for dummies? ›
In order to calculate it, first subtract the cost of goods sold from the company's revenue. This figure is known as the company's gross profit (as a dollar figure). Then divide that figure by the total revenue and multiply it by 100 to get the gross margin.
How do you solve margin problems? ›- Get the population standard deviation (σ) and sample size (n).
- Take the square root of your sample size and divide it into your population standard deviation.
- Multiply the result by the z-score consistent with your desired confidence interval according to the following table:
The definition of a contribution is something that you give or something that you do that helps in achieving an end result. An example of a contribution is when you donate $10 to charity. An example of a contribution is when you come up with a great idea that helps to create a cool finished product.
What is the contribution margin percentage? ›Contribution margin percentage is a financial metric that helps investors and businesses assess the profitability of their operations. One can calculate it by dividing a company's profits from sales by its total sales.
What is contribution method? ›The contribution approach is a presentation format used for the income statement, where all variable costs are aggregated and deducted from revenue in order to arrive at a contribution margin, after which all fixed costs are deducted from the contribution margin in order to arrive at the net profit or loss.
Is contribution margin always a percentage? ›The formula for a contribution margin is fairly straightforward at its heart and can easily be shown either as a ratio or as a percentage. It is calculated as the difference between the total sales revenue and total variable sales.
What is the formula for contribution margin quizlet? ›Contribution margin = Total sales − Total variable costs.
What is the contribution margin approach formula quizlet? ›The contribution-margin ratio = Unit contribution margin ÷ Unit sales price.
How do you convert contribution margin to percentage? ›- Step 1 → Calculate the Contribution Margin (Selling Price Per Unit – Variable Cost Per Unit)
- Step 2 → Divide the Contribution Margin by the Selling Price Per Unit.
- Step 3 → Multiply the Resulting Ratio by 100 to Convert into Percentage Form.
The Contribution margin per unit is the selling price of one unit of goods minus the variable costs of making that unit. The contribution margin per unit is the amount of money each sale contributes towards paying fixed costs. Once the fixed costs are paid, it will indicate how much profit is earned per unit sold.
How do you calculate growth? ›
To calculate the growth rate, take the current value and subtract that from the previous value. Next, divide this difference by the previous value and multiply by 100 to get a percentage representation of the rate of growth.
How do you calculate contribution per unit from a break-even chart? ›On a breakeven diagram, breakeven is shown by the intersection where Total Revenue is equal to Total Costs. The formula for calculating the breakeven number of units is: The selling price per unit minus variable cost per unit is also known as “contribution per unit”.
How do you determine the overall contribution margin ratio the company's break-even point in total sales dollars? ›A company's total contribution margin in dollars is the total net sales minus the total amount of variable expenses. Dividing the contribution margin in dollars by the total amount of net sales is the contribution margin ratio.
Does contribution margin mean profit? ›Contribution margin is the revenue remaining after subtracting the variable costs that go into producing a product. Contribution margin calculates the profitability for individual items that a company makes and sells.
How do you calculate contribution margin per hour? ›Divide the yearly contribution margin by the number of work hours. In this case, $120,000 divided by 6000 equals $20, your department's average contribution margin per hour.
How do you calculate contribution margin increase? ›Contribution Margin Increase
The equation for contribution margin is the product's revenue minus its variable costs, divided by the product's revenue. If you have a product that earns $50 in revenue, has variable costs of $30, its contribution margin is $50 - $30 / $50 = 0.40 (40 percent).
The 60% ratio means that the contribution margin for each dollar of revenue generated is $0.60.
What does 200% profit margin mean? ›For example, if a product costs you $20 to produce (including the cost of labor) and you sell it for $60, the markup formula is ($60 – $20) / $20 = 200%. In other words, you're marking the product up 200%. Your markup amount determines your profit margin.
What does it mean if a contribution margin is 37? ›This means that for every 10 swimsuits a company sells, 37% of the sales revenue is available to cover fixed costs and provide a profit.
What is a contribution margin for dummies? ›The contribution margin shows how much additional revenue is generated by making each additional unit product after the company has reached the breakeven point. In other words, it measures how much money each additional sale "contributes" to the company's total profits.
What does a 50% contribution margin mean? ›
Typically, you operate at a 50 percent margin, which means you spend approximately $1,000 each month on variable expenses and take in a $1,000 margin to cover fixed costs. The remainder would then serve as your net profit.
What is the best definition of contribution margin quizlet? ›Contribution margin is defined as: Sales revenue minus variable expenses. If sales revenue doubles, variable costs will. increase in total.
What are good contribution margins? ›*50% to 100% is considered a good contribution margin.
A positive contribution margin shows the company's capacity to pay the fixed costs associated with the organization. Further, a negative contribution margin indicates the issues with the product or market.
The variable cost per unit is $2 per unit. Contribution margin per unit formula would be = (Selling price per unit – Variable cost per unit.
How do you use contribution margin to make decisions? ›You can use contribution margin to calculate how much profit your company will make from selling each additional product unit when breakeven is reached through cost-volume-profit analysis. As another step, you can compute the cash breakeven point using cash-based variable costs and fixed costs.
Can contribution margin be over 100? ›Margins can never be more than 100 percent, but markups can be 200 percent, 500 percent, or 10,000 percent, depending on the price and the total cost of the offer. The higher your price and the lower your cost, the higher your markup.
What does the contribution margin of 70 mean? ›This contribution margin ratio tells us that 70% of the sales revenues (or 70% of the selling price) is available to cover the company's $31,000 of monthly fixed costs and fixed expenses ($18,000 + $12,000 + $1,000). Once the $31,000 has been covered, 70% of the revenues will flow to the company's net income.