Published April 22, 2024
Build an understanding of contribution margin, how to calculate it, and the actionable insights it provides for optimizing your decision making.
Contribution margin is a popular and valuable metric because it zooms in on the profitability of a single product. This information provides actionable insights for a business’ sales mix.
A product’s profit contribution can be forecast across the entire life cycle of a product, helping businesses plan for sustained success and extend the life cycle of their business.
Most of the best accounting software options will do most of this analysis for you. And many e-commerce platforms have enough accounting systems built-in to give you the numbers you need. But it’s still valuable to understand what’s behind the numbers and how you can use them to optimize your decision making.
Continue reading to learn more about contribution margin.
Overview: What is contribution margin?
Contribution margin is a measurement of what remains after subtracting variable costs from sales revenue. This leftover revenue “contributes” to fixed cost expenses and profits.
Contributions from sales go to fixed costs and business profits. Image source: Author
Unlike net income, contribution margin provides a look at individual product metrics rather than overall business numbers. It’s a valuable measurement that empowers you to determine how profitable individual products are for your business.
It can be expressed in dollar amounts as total contribution margin or as a percentage with the contribution margin ratio.
How to calculate contribution margin
The contribution margin formula is simple. It looks like this:
Total variable expenses are subtracted from net sales to calculate a contribution margin Image source: Author
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. In the example above, the contribution margin ratio is 65%.
Calculating contribution margin is simple math, but there’s a ton of work that goes into formulating your raw product data.
It’s important how you break down and categorize expenses from your income statement into variable and fixed cost buckets. Not all expenses will cleanly fall into either bucket, so it’s critical that your accounting and financial analysts are consistent with how they classify expenses.
This consistency creates a level playing field for product contribution margin comparison. And though it can be incredibly intensive, constantly and consistently categorizing fixed and variable costs optimizes product-level decision making.
Example of contribution margin
Contribution margin really shines for businesses that have multiple products, but it works for anyone. Let’s take a look at how contribution margin can inform the decision making for a food truck that specializes in sandwiches.
Contribution margin applies to any business, big or small, with one product or one thousand. Image source: Author
Food Co. is a food truck that sells turkey sandwiches, grilled cheeses, and sodas. Laina, the owner, knows their total annual fixed cost will be $100,000. She has limited space on the food truck, so she has to maximize each service before returning to the commissary to reload.
Here’s a breakdown of each product:
- The gourmet turkey sandwich sells for $10 with $7 in variable costs for a $3, or 30%, contribution margin. The high variable cost is due to sourcing and preparing the free-range, organic turkeys that Laina has committed to using for this sandwich.
- The grilled cheese sells for $8 with $2 in variable costs for a $6, or 75%, contribution margin. The low variable cost with the grilled cheese is due to Laina using reliably sourced artisan bread and cheese, so this sandwich is mostly fixed costs.
- Bottled soda sells for $2 with no variable costs for a $2, or 100%, contribution margin. Laina decided against homemade drinks and chose to simply sell bottled sodas. Because of this decision, her only costs associated are fixed costs with purchasing cases of sodas.
With all this information, she can determine her average sales needs by day, week, and month as well as per service. With the reality of these numbers, she’d want to optimize contribution by dedicating more space for and pushing sales for more grilled cheeses.
Another easy win for optimizing contribution margin and break-even would be to offer a sandwich combo special where you add a drink for $1 rather than $2. With sodas having no variable costs, this would boost the contribution margin of the gourmet turkey sandwich to $4, or 36%, and the grilled cheese to $7, or 88%.
This example highlights how businesses can tweak and package products to influence sales while still maximizing contribution margins. Because of the revenue recognition principle, contribution margin applies equally whether your business sells directly to customers or is sold through partners.
What does contribution margin tell you about your business?
Contribution margins provide an aggregate analysis of the profitability of your business’ product portfolio.
The contribution margin of your products indicates their individual profitability measures. This is valuable information when examining a product’s contribution margin in comparison with others.
This product snapshot helps the firm advantageously add and remove products from their portfolio and adjust prices accordingly.
Here are the three most common actions that contribution margins empower businesses to take:
1. Add product to portfolio
Contribution margin is a great measure for adding or keeping products in your product portfolio. Any existing products with a positive contribution margin should remain in your portfolio.
And when sourcing new products to add, estimating the contribution margin provides an accurate and actionable look at how the product will contribute to the overall business profitability.
2. Remove product from portfolio
It’s important to remember that a product’s contribution margin isn’t a static measure. It can change over time as the sales price and variable costs fluctuate. For that reason, a product that was once a great fit for your portfolio may very well need to be eliminated if the numbers turn down.
A negative contribution margin means that you’re losing money with every sale of the product in question. It either needs to be removed or have the price adjusted.
3. Adjust product’s price
You can think of contribution margin as an easy-to-use price threshold. A positive contribution margin means the product price is able to offset variable cost expenses and contribute to fixed cost expenses and profits. A negative margin depletes profits and requires that price be adjusted to combat this, if not pulling the product completely.
This highlights the importance of keeping a constant pulse on a product's contribution margin to eliminate unforeseen changes and ensure sustained profitability.
FAQs
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Gross profit margin and contribution margin are incredibly important business metrics you should constantly monitor. They provide valuable snapshots on your business’ health, each from a different angle so that neither is a substitute for the other.
The primary difference between gross profit and contribution margin is that contribution margin is a profit metric zoomed in on individual products while gross profit highlights your business as a whole.
Gross profit margin is a measure of remaining revenue after subtracting costs directly associated with production from your total revenue. The production costs used to calculate gross profit margin are referred to as the cost of goods sold (COGS). Here’s an example of how to calculate gross profit margin:
- Gross profit margin = total revenue - COGS
- If the total revenue for your business is $10 million and your COGS is $6 million, your business’ gross profit margin is $4 million or 40%.
This metric highlights how successful your overall business is in generating revenue from the costs spent on producing all products in your portfolio.
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You read above how critical and time-intensive it is to categorize variable and fixed costs buckets, but what’s the difference between these two expenses?
- Fixed costs are your constant business expenses. These remain the same regardless of expanding production quantities. Common fixed costs include rents and administrative salaries.
- Variable costs do change as you adjust your production quantities. These include materials for producing products as well as any commission or incentives you place on selling products.
As stated before, it’s critical in the context of contribution margin that accounts and financial analysts are consistent in bucketing fixed and variable costs. This ensures you’re looking through the same lens when you do a deep dive on each of your products.
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Break-even analysis builds off of contribution margin to determine the amount of sales needed for a company to break even between expenses and profits. Every product has a break-even point where it becomes profitable after a certain number of units sold.
If your business had zero fixed costs and a positive contribution margin, then you’d hit your break-even point on your first sale.
To calculate a break-even point, calculate the contribution margin for a product and then divide the fixed cost expenses by it. The results will show how many units of the product your business must sell to break even.
Here’s an example:
- Your business sells 100 products at $1,000 per product. Total fixed costs are $35,000 for this $100,000 in sales.
- Variable costs are $300 per product, thus the contribution margin is $700 or 70% per product.
- Your break-even point is when your cumulative contribution margin exceeds your total fixed costs. In this case, you hit your break-even point once you sell 50 products or $50,000 in sales. Here’s the math for both:
1. Total fixed costs ($) / Contribution margin ($) = Break-even point (products)
$35,000 / $700 = 50 products
2. Total fixed costs ($) / Contribution margin ratio (%) = Break-even point ($)
$35,000 / 0.7 = $50,000
Contribution margin provides critical business insight
Contribution margin is an excellent tool for analyzing and ranking products. It provides an accurate and actionable look at profitability from product to product, but it shouldn’t be considered in a vacuum.
Contribution margin is one of many business metrics that successful companies keep in their toolbox. These analysis tools work together to inform and optimize your decision making so that you can propel your business forward.
Our Small Business Expert
Experienced content leader empowering businesses of all sizes to employ the strategies and technologies needed to generate growth and sustain success. Always excited to analyze trends, conduct interviews, and dig into the data to build helpful content for readers across industries and disciplines. My work has been cited in notable publications like The New York Times, Forbes, CNN, and TIME Magazine. I’ve also been featured on numerous market/industry-specific blogs such as Groupon’s merchant blog and Yelp’s business center blog.
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