As a business owner, you always want to know how much goes into making your products. From materials to labor to rent, ample costs are associated with your company's output. And these costs all weigh heavily on your profits. Just look at the balance sheet in your accounting software they'll tell you as much.

You'll often turn to profit margin to determine the worth of your business. It's an important metric that compares a company's overall profit to its sales. However, if you want to know how much each product contributes to your bottom line after covering its variable costs, what you need is a contribution margin. 

 In short, profit margin gives you a general idea of how well a business is doing, while contribution margin helps you pinpoint which products are the most profitable. 

How to calculate contribution margin

Calculating the contribution margin is quite straightforward. 

Using this formula, the contribution margin can be calculated for total revenue or for revenue per unit. For instance, if you sell a product for $100 and the unit variable cost is $40, then using the formula, the unit contribution margin for your product is $60 ($100-$40). This $60 represents your product's contribution to covering your fixed costs (rent, salaries, utilities) and generating a profit.

In the same case, if you sell 100 units of the product, then contributing margin on total revenue is $6,000 ($10,000-$4,000).

You can even calculate the contribution margin ratio, which expresses the contribution margin as a percentage of your revenue. 

Here's the formula to calculate the contribution margin ratio:

In the same example, CMR per unit is $100-$40/$100, which is equal to 0.60 or 60%. So, 60% of your revenue is available to cover your fixed costs and contribute to profit.

The higher a product's contribution margin and contribution margin ratio, the more it adds to its overall profit.

Now, you might have a question: What are these variable and fixed costs we’re talking about? 

Fixed cost vs. variable cost

Fixed and variable costs are expenses your company accrues from operating the business.

Fixed cost

You pay fixed expenses regardless of how much you produce or sell. It includes the rent for your building, property taxes, the cost of buying machinery and other assets, and insurance costs. Whether you sell millions of your products or 10s of your products, these expenses remain the same.

Some examples of fixed costs are: 

• Rent or lease payments
• Salaries and benefits
• Interest expenses
• Insurance 
• Property taxes 

Variable cost

Variable expenses directly depend upon the quantity of products produced by your company. These.include materials, labor, packaging, and equipment. For example, if the cost of raw materials for your business suddenly becomes pricey, then your input price will vary, and this modified input price will count as a variable cost. 

Here's a list of variable costs:

• Raw material
• Packaging costs
• Shipping charges
• Utilities
• Commissions

How do companies use contribution margin?

 Companies use contribution margins to assess their financial health and make strategic decisions.

• Product profitability analysis: Consider a company with more than 10 different product lines. By comparing the contribution margins of their offerings, they see which product contributes to overall profit by generating the money to cover fixed costs. This informs decisions about product pricing, resource allocation, marketing strategies, or even product discontinuation. 
  
  A product with a high contribution margin is an ideal candidate for receiving more resources in marketing and promotion, while a product with a low or negative contribution margin is ideal for elimination.
• Break-even analysis: his analysis helps decide the sales volume needed to cover all costs and reach the breakeven point where total revenue equals total costs. Knowing the contribution margin allows companies to calculate the breakeven sales level. This makes sure businesses aren’t selling products at a loss.
• Cost management: Analyzing contribution margin aids in identifying areas for cost reduction. By understanding how much each product contributes to profit, leadership can focus on optimizing variable costs associated with less profitable products. 

Why is contribution margin important?

The contribution margin is important because it gives you a clear, quick picture of how much "bang for your buck" you're getting on each sale. It offers insight into how your company’s products and sales fit into the bigger picture of your business. If the contribution margin for a particular product is low or negative, it's a sign that the product isn’t helping your company make a profit and should be sold at a different price point or not at all. It’s also a helpful metric to track how sales affect profits over time.

Investors often look at contribution margin as part of financial analysis to evaluate the company's health and velocity. For example, if a company has more than 10 product lines, investors study the contribution margin of each product to see if the company is properly investing in products with high contribution margins instead of those lagging behind.

How to improve contribution margin

Companies can improve their contribution margin to better their financial standing in two ways.

1. Increase revenue by selling more units, raising product prices, shrinking product size while keeping the same cost, or focusing on selling products with high margins.

2. Reduce variable costs by getting better deals on raw materials, packaging, and shipping, finding cheaper materials or alternatives, or reducing labor costs and time by improving efficiency. 

It's crucial to strike a balance between these two approaches. For example, raising prices increases contribution margin in the short term, but it could also lead to lower sales volume in the long run if buyers are unhappy about it. Before making any changes to your pricing or production processes, weigh the potential costs and benefits. Don’t make any changes that'll alienate your customer base. 

Contribution margin vs. gross margin

Both contribution margin and gross margin are profitability metrics, but they consider different things:

• Gross margin focuses on overall profitability. It takes into account the price of producing goods and subtracts it from the revenue to see how much money remains. It shows you how efficiently a company converts its costs into sales.
• Contribution margin examines individual products and their profitability. It takes revenue and subtracts variable costs to reveal how much each product contributes to covering fixed costs and profit.

Get calculating

Now that we’ve reviewed the basics of contribution margin ratio, it’s time to calculate it yourself. Use the formula we went over and find your contribution margin so you make better strategic decisions about your business.

Want to crunch more numbers? Learn about the time interest earned ratio and how to calculate it.