Understanding Contribution Margin

Contribution margin measures a product’s profitability by subtracting variable production costs from the final price. That profit can be used to cover—or “contribute” to—the company’s fixed costs.

Today, we’ll dive into the many benefits of the contribution margin, explore how it differs from gross margin, and discuss why businesses like yours need to carefully and correctly calculate it.

Calculating the Contribution Margin

The contribution margin formula is simply revenue minus variable costs.

Let’s say you have a product that sells for $5,000. You determine that the variable costs to produce the product are $2,000. When this amount is subtracted from the revenue, you’re left with a $3,000 contribution margin.

If you want to figure out the contribution margin ratio, you’ll take the contribution margin ($3,000) and divide it by the revenue ($5,000). Then, multiply the result by 100 to convert it into a percentage. In this scenario, the contribution margin ratio is 60%. The closer the contribution margin ratio is to 100%, the more money you’ll have available to pay your fixed costs.

Sounds easy, right? Unfortunately, there is a slight catch: you must first differentiate between your variable costs and your fixed costs.

Fixed vs. Variable Costs

Fixed costs are business expenses that are set forth in a contract or a schedule and remain the same, regardless of how many goods you produce or services you deliver. Examples of fixed costs include rent, salaries, insurance, and property taxes. Variable costs, on the other hand, are expenses tied directly to your production or sales volume. Examples of variable costs include raw materials, labor, commissions, and utilities.

It’s important to know that some costs may be what Investopedia calls semi-fixed or mixed costs. “These types of expenses are composed of both fixed and variable components. They are fixed up to a certain production level, after which they become variable….[F]ixed costs occur regularly while variable ones change as a result of production output and the overall volume of activity that takes place.”

When you’re calculating contribution margin, remember the difference between these costs and apply them appropriately within the contribution margin formula.

Contribution Margin Is Not Gross Margin

Before we examine how the contribution margin can help you measure product profitability, let’s quickly address the difference between contribution and gross margins.

Contribution margin is revenue minus variable costs and is most often used to analyze the breakeven point for an individual product or service. The gross margin is net sales minus the cost of goods sold (COGS), which is the cost of the materials and labor used to create a specific product. Gross margin is most typically a measure of a company’s overall profitability.  Contribution margin factors in only the variable costs while gross margin includes all variable and non-variable costs of production.

To get the gross margin ratio, divide the difference by the net sales and multiply by 100. For example, let’s say a company makes $500,000 in net sales, and the COGS is $300,000. So, the gross margin would be $200,000, and the gross margin ratio—($200,000 / $500,000) x 100—would be 40%.

The gross margin shows how well a business is performing financially. A high gross margin signifies an efficient operation, while a low gross margin indicates the business needs to find ways to reduce costs and improve sales.

Practical Applications in Business

How does knowing the contribution margin for your products or services help your business? It indicates how well certain products or services are performing and whether you’re selling enough to cover all of your operating costs—which is also known as the break-even point (BEP).

To calculate your BEP, take the fixed costs of a product and divide that number by your contribution margin per unit. This will tell you how many units you need to sell to break even.

Let’s say you have a contribution margin of $3,000, and the fixed costs of production add up to $24,000. In this case, the break-even point ($24,000 divided by $3,000) would be 8. So, you would need to sell 8 units to break even.

Knowing your BEP will help you decide if you should continue to invest in a product or service based on profitability.

The contribution margin can also help you:

• Price your products and services.
• Structure your sales commissions.
• Allocate your resources (e.g., materials, labor, etc.) effectively.

As with any financial metric, it’s wise to use the contribution margin in conjunction with other metrics (like gross margin) to make vital financial decisions.

Conclusion

Ultimately, the contribution margin is a practical way to measure how well your business is covering operating expenses. With it, you’ll have granular-level insights into the profit-making potential of every product or service you create. Your ability to accurately calculate and monitor your contribution margin is largely dependent on the access you have to quality data. A modern business management solution that serves as a reliable centralized database will help ensure that you have the data you need.

As a flexible, innovative, cloud-based ERP solution, Acumatica stores all your organization-wide data in one place, so you can access it anytime, from anywhere. It connects every department with a single system, providing unparalleled, real-time data visibility and delivering essential decision-making tools. You can also use Acumatica to automate workflows, customize reports, and seamlessly integrate with third-party applications.

Acumatica customer Bryan Papé, Founder and CEO, Miir, says, “Acumatica has allowed us to be a better digital business. From Sales to Operations, from Admin to C-Level Executives, Acumatica allows us to have insight into data to make good decisions to grow our business in a powerful way.”

To learn more about how Acumatica can help make your business profitable one product and service at a time, contact our experts today.