What is Contribution Margin?
The Contribution Margin represents the revenue from a product minus direct variable costs, which results in the incremental profit earned on each unit of product sold.
Since the associated variable costs are accounted for, the contribution margin represents the remaining revenue left to pay for fixed costs and other non-operating expenses.
How to Calculate Contribution Margin (Step-by-Step)
While there are various profitability metrics – ranging from the gross margin down to the net profit margin – the contribution margin (CM) metric stands out for the analysis of a specific product/service.
The contribution margin is the profits generated after variable costs have been deducted – i.e. how much revenue exceeds the associated variable costs.
Instead of looking at the profitability of a company on an overall basis with all products grouped together, the CM enables margin analysis on an individual product line basis.
In particular, the use-case of the metric tends to be most applicable for setting prices appropriately.
If the margin is too low, the current price point may need to be reconsidered. In such cases, the price of the product would either be:
- Increased Pricing → The pricing of the product line could be raised to contribute towards more profitability, as the current profit margins are unsustainable
- Discontinued → The product offering could be discontinued if there is insufficient customer demand after a potential price increase.
Additionally, the assessment of the CM can help determine optimal pricing by assessing the impact each change would have on revenue and profitability levels.
Given how the CM examines the product-level breakdown of each dollar that comes in and how it contributes to generating profit, the break-even point cannot be calculated without determining the CM.
For companies seeking to obtain a sustainable long-term competitive advantage, it’s important to focus on identifying the products with the highest contribution margins in order to maximize potential profits.
Contribution Margin Formula
The calculation of the metric is relatively straightforward, as the formula consists of revenue minus variable costs.
Just as a quick review, a company’s variable costs are directly associated with revenue and fluctuate based on production volume, whereas fixed costs remain unchanged regardless of production volume.
- Variable Costs → e.g. Purchase of Inventory/Materials, Direct Labor, Shipping Costs
- Fixed Costs → e.g. Utilities, Rent, Insurance, Equipment
All else being equal, the greater the CM of each product, the more profitable the company is going to be, with more cash available to meet other expenses.
The distinction pertains to the concept of scalability, as companies with higher variable costs tend to bring in fewer profits since the direct costs increase (and can offset) the growth in revenue.
Contribution Margin Ratio Formula
To perform a more detailed analysis on either a quarterly or year-over-year (YoY) basis – or comparisons to comparable companies in the same industry – the CM can be divided by revenue to get the CM ratio.
To go through a simple example, let’s say there’s an e-commerce company selling t-shirts for $25.00 with variable costs of $10.00 per unit.
- T-Shirt Cost = $25.00
- Variable Cost Per Unit = $10.00
The formula used to calculate the margin would be as follows:
- Margin = $25.00 – $10.00 = $15.00
Next, the CM ratio can be calculated using the following formula:
- CM Ratio = $15.00 ÷ $25.00 = 0.60, or 60%
The 60% ratio means that the contribution margin for each dollar of revenue generated is $0.60.