Comparing profits to costs can help you determine your business's profitability and ensure your sales prices remain competitive. Many companies have fixed and variable costs that change from product to product and month to month. Knowing how your costs affect your profits is crucial to understanding your business's financial health.
One way companies determine their profitability is by looking at the contribution margin (CM), which demonstrates the amount generated for each unit sold after subtracting various expenses. This metric sounds like a profit margin calculation, but the two are quite different.
The contribution margin can help you price products and ensure your business earns enough while remaining competitive. Keep reading to learn more about this financial calculation and how you can use it to optimize your company's profitability.
Understanding contribution margin
Contribution margin is the difference between the sales price and variable cost per unit. So what is a contribution margin ratio? It's an example of a KPI that affects your business's financial health. It measures how profitable a particular product is for a company.
The contribution margin ratio is expressed as a percentage and takes into account variable costs that fluctuate with the units produced, which may include costs related to packaging, labor, and raw materials used in production.
This calculation doesn't include fixed costs but can tell you how much revenue remains for fixed costs. Using the contribution margin formula shows what percentage of revenue is left over after factoring in variable, fluctuating costs.
This number is typically used to help companies measure their profits and find ways to lower their variable costs. This calculation can also be used to determine prices for various products to ensure they earn enough revenue to make a profit on any sales. For instance, you can use this calculation to price your products based on current market conditions and variable and fixed costs.
Contribution margin sounds similar to profit margin, so confusing the two is easy. Your gross profit margin is the income you receive minus the cost of goods sold, including all fixed and variable costs like shipping and handling, production, and so forth. On the other hand, the contribution margin ratio subtracts variable costs from your sales.
Companies typically use this metric to determine how much revenue they generate by producing each additional unit after breaking even, measuring how much new sales contribute to their profits. The gross profit margin represents a company's total profits, while the contribution margin only refers to the earnings per unit. Typically, investors like to see a company's profit margin in their pitch deck, while the contribution margin ratio is used for internal business decision-making.
Determining your contribution margin per product or product line can ensure each unit is profitable and allow you to determine whether prices make sense in a competitive marketplace. This calculation can also help you decide whether or not it's worth it to continue selling a specific product or line while streamlining sales and operations. Ultimately, the key financial data you obtain is valuable for improving business decision-making.
How to calculate contribution margin ratio
It's fairly easy for any small business owner to calculate their contribution margin ratio. The CM ratio formula is as follows:
The result will be a ratio, which you can multiply by 100 to get a percentage that compares the margins per unit to the price per unit, allowing you to understand the various costs associated with a specific unit or product.
In the CM ratio formula, the variable costs are those directly related to the production volume, such as parts and labor.
Let's take a closer look at an example to help you understand how to find the contribution margin ratio:
A company only has one stock-keeping unit (SKU), so they only sell one unit. After careful consideration, their selling price per unit is $50, while their variable costs per unit are $10. Now, let's enter those numbers into the CM ratio formula:
Contribution margin = (50 - 10)/50 = 80%.
A contribution margin ratio of 80% means 80% of this company's revenue is available for fixed costs, which can be subtracted from the contribution margin to give you a profit margin. In other words, 20% of this company's profits are used for variable costs per unit.
What is a good contribution margin ratio?
Typically, most companies should aim for a high contribution margin ratio because it means they're making more than they spend. A low contribution margin can signal that a specific product is too expensive and not contributing to a company's overall profits.
A high contribution margin ratio means you have enough revenue to cover fixed costs and overhead associated with producing or selling a product. However, what you consider a good ratio will depend on your industry and the business's variable costs.
Low contribution margins are common in some industries, specifically those with higher variable costs. For example, labor costs tend to be higher in the manufacturing industry.
How to improve contribution margin
All businesses should strive to improve their contribution margin because it means spending less on variable costs and ensuring higher profits that cover your fixed expenses and increase profit margins. Unfortunately, the contribution margin ratio formula only has 2 metrics: your variable costs and selling price per unit. Therefore, there are really only 2 ways to boost your contribution margin:
Reducing variable costs
Reducing fluctuating costs can dramatically increase your contribution margin, giving you more to spend on fixed expenses or to take as profit. The lower your overall costs, the more you stand to make on each sale, so keeping your variable costs as low as possible makes sense.
Some expected variable costs for companies include certain types of marketing materials, shipping, and labor. There are many ways to reduce these costs; for example, you can find alternate service providers. However, reducing the quality of your products could inevitably hurt your business reputation and sales, so you should be mindful of where you cut variable costs and when.
Increase revenue
The second way to improve your contribution margin is to increase revenue on products sold. When you increase your revenue, you effectively reduce the percentage of revenue that goes toward paying variable costs.
Increasing your revenue doesn't necessarily mean raising selling prices, although it can. Before introducing higher prices, you can invest in marketing to help sell more goods and boost revenue.
You can also consider various pricing methods to increase your contribution margin without losing customers. Unfortunately, increasing your prices and investing more in marketing can result in lower contribution margins if you're not careful. For instance, if you spend too much on advertising without any growth in sales, you'll have a lower contribution margin.
Limitations of contribution margin ratio
Calculating your contribution margin ratio can help you make better business decisions. However, it's not the only metric you should track to get an accurate picture of your company's financial health since it has limitations and drawbacks. This includes:
- Misleading calculation possibility. Expenses can be classified as fixed when they're actually variable, resulting in misleading information that makes you believe your contribution margin ratio is much lower. Since this metric is used to determine how well a specific product supports your business goals, it's crucial to categorize your expenses properly.
- Can negatively influence decisions. While a misleading calculation can lead to adverse consequences for your business, you should never make assumptions or significant decisions about a product or product line based solely on the contribution margin ratio. For instance, a product line with a low margin may sell in high volumes, making it profitable because it doesn't require any extra effort.
- Not a direct representation of profits. The contribution margin ratio ignores other factors that can impact the success of a product or product line, such as internal processes like management or changes in the technology you use. Therefore, it can't definitively tell you your profits because it overlooks costs unrelated to production.
Understanding your contribution margin
The contribution margin is the percentage of revenue for a given product that a company earns after breaking even, and it's just one important metric you can use to make decisions about your business. However, your decision-making process must include several other financial considerations and figures.
Reducing your variable costs can increase your contribution margin and overall profits. Mailchimp's all-in-one suite of marketing tools gives you everything you need to market your business and find new strategies that reduce costs and grow your profits. Try Mailchimp today.
