When taking a look at how your business is doing financially, it’s tempting to focus all your attention on the “bottom line.” In other words, are you turning a profit or not? If the answer is yes, many business owners might stop there, pat themselves on the back, and vow to keep doing more of the same. But there’s always room for improvement. And the things you’re doing now may not continue to work as the business grows. One metric to keep an eye on, particularly for businesses that produce physical products, is contribution margin.
A business’ contribution margin shows how much money is left over after variable costs are removed to cover fixed costs. It’s a metric that’s rarely shared publicly but rather is used by managers and leadership to make decisions.
The overarching goal of the contribution margin to help these key players improve the production process by analyzing their variable costs and (hopefully) finding ways to bring them down.
Contribution Margin Formula
The formula for contribution margin is simple and just involves a little subtraction. Here’s what it looks like:
Net Sales – Variable Costs = Contribution Margin
The two primary variables here are net sales and variable costs, both of which can be found on an income statement.
Net sales is often referred to simply as revenue. It’s all the money your business brought in, excluding only allowances and returns. It’s usually the first thing you see on an income statement before all expenses are taken out to get to the “bottom line.”
Variable costs also live on the income statement, but they’re not as easy as net sales to find. Instead, they’re usually listed as line items within cost of goods sold, right alongside fixed costs.
So finding your variable costs may involve adding up all the relevant line items from your income statement and then subtracting that amount from your net sales.
Variable costs, generally speaking, are those expenses that fluctuate from month to month, usually in direct relation to your sales. For example, if you run a dog grooming salon and have a strong month with more pups than normal stopping by, you’ll need to buy more shampoo to keep up with demand. The shampoo is a variable cost in this scenario.
Common examples of variable costs include:
- Raw materials
- Labor costs
- Shipping costs
Difference Between Fixed & Variable Costs
So if variable costs go up or down depending on how your business does that month, what are fixed costs? Fixed costs are, as the name implies, relatively static. Whether you have a great month or a terrible month, you’ll still need to pay all your software subscriptions, rent, and phone bills.
The division between fixed and variable costs can depend largely on your business. A consulting business with a traditional office space may consider the water bill, for example, a fixed cost. But a dog grooming business that uses water to provide their service would almost certainly consider the water bill a variable cost. The more dog washes they do, the higher that bill.
This is why parsing variable costs from fixed costs is a relatively manual process that the income statement doesn’t naturally break out.
Contributed Margin Example
Let’s dig a little deeper into our dog grooming example to see the contribution margin at work. Let’s say that Pup n Suds Grooming brought in $40,000 in revenue last month. When they look at their income statement, they see the following variable costs:
- Materials (ex. Shampoo): $1,500
- Payroll: $18,000
- Water Utilities: $1,200
- Dog Treats: $200
Adding these variable costs up, Pup n Suds spent $20,900 on variable costs. If we subtract that from the $40,000 they brought in through sales, we know that they have $19,100 left over to cover fixed costs (and hopefully still have some left over after that).
$40,000 – $20,900 = $19,100
High vs. Low Contribution Margins
Generally speaking, you want your contribution margin to be as high as possible. A high contribution margin means that you make more from your products than they cost to produce and are in a strong position to cover your fixed costs. A low contribution margin simply means that your margins are slim and that you’ll need to sell a high volume to make a decent profit and pay your fixed costs.
Your contribution margins can also be assessed on a product-specific level. So if you produce a wide variety of products, calculating the contribution margin for each product will help you understand which ones are your top performers and which ones you should consider dropping.
Of course, a product’s contribution margin is simply one factor to consider when evaluating your product line. Attempting to trim costs may not be the best route for luxury products with low contribution margins, but raising prices could be a better alternative. Businesses should take their customer expectations, brand, and internal standards into account as well.
Other Relevant Formulas
The main drawback of the contribution margin formula is that it leaves business owners with a dollar amount. So deciding what a strong margin looks like is subjective. Luckily, there are a few other ways to look at contribution margin that can help business owners look at their overall contribution margin and product-specific margins with more objectivity.
Contribution Margin Per Unit
One of the best ways to track the performance of specific products is to calculate the per-unit contribution margin. This metric essentially shows you how much money you’ll earn on each sale, once the cost of producing that item (its associated variable costs) has been subtracted.
Here’s the formula:
(Product Revenue – Product Variable Costs) / Units Sold = Contribution Margin Per Unit
The key to using the formula above is to find only the revenue that comes from sales of a specific product or product line, along with that product’s specific variable costs. This can be a little harder to parse out than simply looking at an income statement.
Contribution Margin Ratio
To build on the per-unit contribution margin metric, business owners can also find their contribution margin ratio. The benefit of ratios is that they take dollar amounts out of the picture, allowing you to compare product margins side by side—without taking sales volume into account.
Here’s the formula:
Contribution Margin Per Unit / Sales Price Per Unit = Contribution Margin Ratio
Sales volume is still an important facet of contribution margin to keep in mind, but the ratio allows you to quickly compare your products. It gives you another lense through which you can view your financial information and make informed decisions.
Want to learn more about how to manage your business? Make sure to check out the ScaleFactor blog.