For some businesses, profitability is looking at a profit and loss statement and checking the net income. This works to ensure that more money is coming in than going out, but it doesn’t tell you much beyond that.
That’s why finance teams look at different profitability metrics to measure performance. Each metric looks at profitability through a different lens to get the full story of how the business is generating profit and whether it’s financially healthy.
One such metric is contribution margin, and it’s one you need to know to understand whether your business is scalable.
What is contribution margin?
Contribution margin shows how much sales revenue is left to cover fixed costs and profit after subtracting variable costs. It’s a key metric for understanding product profitability and helps guide pricing, product choices, and business strategy.
To illustrate contribution margin, think about a dropshipping company: on every sale, the business pays a supplier to fulfill the order. If the business sells something for $20 and the supplier cost is $15, the contribution margin on a single unit is $5.
For other business types, variable costs are more complicated, but the principle is the same. You may need to calculate the cost of raw materials, production labor, shipping supplies, and payment processing fees to find your contribution margin.
What are variable costs?
To understand contribution margin, you need to understand variable costs.
Every expense is considered either a fixed or a variable cost.
Fixed costs stay the same regardless of business activity, with examples like rent, salaries, and insurance. Regardless of the number of sales a business processes, these costs will remain the same.
Variable costs change proportionally with sales activity. This includes costs like raw materials, shipping costs, and labor used in production.
You need to have a clear delineation of variable costs to perform a contribution margin calculation and analysis.
Why contribution margin matters
Contribution margin is a measurement of a business’s profit potential. When you know your contribution margin, you know whether you’re generating enough net income on sales to cover your fixed costs.
This type of analysis is called break-even analysis: understanding the volume of sales necessary to generate enough contribution margin to cover the fixed costs.
As an example, consider a business that sells phone cases for $30 with a per-unit variable cost of $20. This means their per-unit contribution margin is $10.
If the business has $10,000 in monthly fixed costs, it needs to sell 1,000 units in a month to break even (called the break-even point). If the average monthly sales are below that figure, they’re likely to lose money every month.
Understanding a business’s contribution margin is understanding how likely it is to turn a profit.
This also applies to analyzing future ventures, such as a new product or service line. If you have an estimate of the variable costs, you’ll know what price level is necessary to be cash positive. And if you have fixed costs associated with the new good or service, you’ll know what volume you need to move to cover those costs.
What is the contribution margin ratio?
Contribution margin can be calculated on the total sales or per-unit basis. But it can also be presented as a dollar amount or a percentage of sales.
When contribution margin is presented as a percentage of sales, it’s called the contribution margin ratio.
Using a prior example of a $30 sales revenue and $20 in variable costs, the contribution margin is $10. The contribution margin ratio in this situation would be 33% ($10 divided by $30).
Contribution margin ratio is best used for comparative analysis, like comparing the contribution margin ratio of different products or services to see where a business is retaining the greatest proportion of its sales revenue.
How to calculate contribution margin
There are three ways to calculate the different types of contribution margin. Here’s how.
Contribution margin formula
The contribution margin calculation involves two values: sales revenue and variable costs. With those values, simply enter them into the formula below:
This calculation can be done on all sales or for a specific good or service.
Contribution margin ratio
Calculating the contribution margin ratio adds in an extra step of dividing by the sales revenue value. The formula for contribution margin is:
Remember that the contribution margin ratio is a percentage. This formula will result in a decimal value which can be multiplied by 100 to get the percentage value (e.g. 0.75 multiplied by 100 gets a percentage value of 75%).
Per-unit contribution margin
An additional calculation is the per-unit contribution margin: how much contribution margin is generated on a single sale. This is best done on the product or service level.
The formula for per-unit contribution margin is:
With the per-unit contribution margin, you can calculate the number of sales necessary to cover your fixed costs and break even.
Contribution margin vs gross profit margin
Contribution margin and gross profit margin are two different calculations that look at the amount of money pocketed by a business on their sales, with the key difference being the costs that are included in the calculation.
Gross profit margin is the difference between sales revenue and cost of goods sold.
Costs of goods sold are just one of the variable costs used in the contribution margin calculation. This means the gross profit margin calculation doesn’t include additional variable costs like production labor, shipping costs, or variable utilities.
As a result, gross profit margin will typically be equal to or greater than contribution margin.
How to improve contribution margin
The contribution margin calculation involves two components: sales revenue and variable costs.
This means that if you want to improve contribution margin, you need to either increase sales revenue or decrease variable costs.
Starting with sales revenue, you may be undercharging for your goods or services. Conduct market research to see how your offerings compare in price to competitors, as you may need to increase your prices.
There are more options to explore when it comes to reducing your variable costs. Some options include:
- Investing in new equipment or machinery to increase efficiency
- Exploring alternative suppliers for raw materials or shipping
- Working with suppliers to get discounts on bulk orders
- Reduce labor inputs by leveraging automation
Improving contribution margin requires creative problem solving, collaboration, and research. Explore every possible avenue, including those with an upfront cost if affordable, knowing that the improvement in efficiency pays off in the long run.
Contribution margin calculation and analysis example
An athletic clothing company is looking to grow its business with a major marketing push. They’ve decided to use their profit from the previous month to fund the initiative.
But the finance team wants the marketing team to put the majority of the spend behind the products that make the business the most money, as measured by contribution margin.
To start, they calculate the fixed costs to be $20,000 and allocate the variable costs by product.
They also divvy up the sales revenue by each clothing item and compile their findings in a table.
By taking the total contribution margin ($37,250) and subtracting the fixed costs ($20,000), the profit is calculated to be $17,250. This is how much they have to spend on marketing.
Then, they look at the contribution margin ratio and per-unit contribution margin for each product. From here, they can see that:
- The highest contribution margin ratio comes from shorts
- But shorts have a per-unit contribution margin of $30
- They get a higher per-unit contribution margin of $50 from jackets
With this information, the business decides to focus on marketing shorts and jackets.
Jackets generate the most contribution margin for the business, but the high price point may make it hard to move volume.
Meanwhile, shorts, at the lower price point, could sell a higher volume. The business would keep a higher percentage of the sales revenue generated on every sale.
Increasing contribution margin through automation
One variable cost to consider when calculating contribution margin is the administrative cost of processing an invoice. If you’re relying on manual accounts receivable processes, you’re cutting into your contribution margin and leaving precious dollars on the table.
By switching to a platform with automation, you get to keep more money from every sale and improve the payment experience for the customer.
With BILL, you get access to templates for ease of creation and integrations with top accounting systems saves you from entering data in multiple places. And recurring invoices can be completely automated, sending on a schedule of your choosing.
Reach out for a demo to see how BILL can help improve your contribution margin.
