Contribution Margin: Definition And Formula (With Example)
Updated 14 October 2022
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A company becomes profitable when it sells enough products and services to cover its expenses and has revenue left over after paying those bills. Business leaders use a variety of metrics to measure the profitability of a business. If you are involved in business management or sales, learning about different ways to measure profitability, like using a contribution margin, can help you in your career. In this article, we define these margins, describe some reasons why this value is important to business leaders, explain how to calculate this value for a product and share an example.
What Is A Contribution Margin?
In companies that sell products, a contribution margin is the amount of money, or profit, a product might generate for the company in a normal economy. It is also called the gross operating margin. In simple terms, it is the difference between the amount it costs to make a product and its sale price. A company's product development and sales teams might collaborate to determine this value for each product the company sells, based on market conditions, past sales numbers and competitor information.
While this value can give company leaders an estimate of a product's profitability, it might change due to external factors, like changing material costs. For example, a furniture company might sell a wooden table for a certain price. Under normal economic circumstances, the table might yield a consistent revenue. One year, logistical issues might cause a lumber shortage, so the company might pay more money for the materials to make the table. If the company keeps the price of the table consistent, the product might generate less profit than estimated because the margin is smaller.
Related: What Are Profitability Ratios? (With Types And Examples)
Why Is This Value Important?
Here are some reasons that this value can be important to businesses:
It helps with break-even analysis
Break-even analysis is a key process for business leaders, like CEOs, CFOs and sales managers, who work in newly established companies. This process helps company leaders identify how many sales the company needs for it to reach the break-even point and become profitable. Starting a company carries a variety of fixed and variable costs, including rental or purchase fees for offices and manufacturing spaces, legal and administrative fees, employee salaries and material costs. For the first few months or years that the company operates, it may only make enough money to pay these costs.
Knowing how much money each product unit generates when compared to its manufacturing costs can help a company's leadership team make plans to reach the break-even point more quickly. They might focus on expanding sales, which allows the company to create products more quickly, or on developing new products with lower production costs to increase earnings.
Related: Calculating Break-Even Analysis In Excel: A Complete Guide
It helps leaders predict revenue
While this value is only one metric that company leaders can use to predict revenue, it can be a useful way to forecast how much money the company might make from certain product lines. A company might hire market analysts to conduct research on current consumer trends, which can help the sales director predict how much of a certain product the company might sell in the next quarter or year. Once the sales director has a prediction for total sales, the margin can help the company's leaders translate the sales revenue into money for fixed costs.
This value can also help a company's management team understand the impact of added production on total revenue. As a company becomes more established and begins to create products in large amounts, the cost to create additional items might decrease. Monitoring the margin helps the company's directors make decisions about when to start buying materials in bulk or begin a mass production campaign.
Related: What Is Revenue? Definition, Types, Examples And More
It helps leaders evaluate product performance
The goal of most companies is to make enough money to cover fixed costs, like wages and rent, and have money left over for growth and investment. By prioritising products with higher margins, a company's product development and sales teams can maximise the amount of money the company makes per sale. This value can tell a company's board of directors which products are most profitable.
For example, a health products company might sell two similar shampoos at different price points. While one shampoo may be slightly more expensive to make, its higher cost means it has a higher margin. Depending on the sales numbers for each shampoo, the company's leadership team might choose to discontinue the less expensive shampoo as it does not bring in a large amount of revenue per sale. That way, the company can focus on increasing sales for the more expensive, higher-margin product.
Related: What Is Cost Management? (With Importance And Steps)
It helps product developers create new items
Along with sales data, this value can be useful when a company's product development team decides to create a new product for sale. By imitating the most cost-effective products, they can increase the chances of creating an item that generates lots of revenue for the company. Understanding the margins on similar products can also help these professionals request an appropriate manufacturing budget for new items.
For example, the production team at a company that produces medical devices might be developing a new type of syringe. To maximise the company's profits, they might examine the most profitable devices that the company currently sells and model the new syringe's production on them. They might choose materials or production methods that have been successful with profitable devices in the past.
Related: Product Analyst Vs Product Manager: Learn The Difference
How To Calculate This Value
You can calculate the value of this metric by using this formula:
Contribution margin = product price - variable costs
Here are three steps you can take to calculate this value for a specific product:
1. Determine the price per unit for the product
The price per unit is the cost to the consumer to buy the product. For example, a shoe company might produce an athletic shoe and sell it for ₹3,140 in the company's storefront location. If the product has a different price in different regions, you can do separate calculations to find the margin in each region and then find the average of all the values.
Related: What Is Cost Unit? (Definition, Calculation And Examples)
2. Identify fixed and variable costs for the product
A business's fixed costs stay the same for all levels of production, like rent or employee salaries. Variable costs change based on a variety of factors, including how many units of a certain product that a company creates. They might include materials costs, marketing expenses and sales commissions. Typically, variable costs increase as the company creates more units, but the rate of increase might slow as the company begins mass production.
Fixed costs may not have a per unit value. For example, the shoe company might pay the same amount of rent for a storefront, whether the company makes 10 pairs of shoes or 100. Because variable costs change based on how many units the company produces, you can estimate the variable cost per unit by dividing the cost of materials, sales commission and other values by the number of units produced. In the shoe store example, each shoe might have a variable cost per unit of ₹2,090.
Related: How To Calculate Variable Cost In 3 Steps (With Examples)
3. Subtract variable cost per unit from the price per unit
Finally, you can use the formula to find the margin or example, if each pair of running shoes has a variable cost per unit of ₹2,090 and generates ₹3,140 in revenue, this is what the equation might look like:
Contribution margin = ₹3,140 - ₹2,090 = ₹1,050
Each pair of shoes sold contributes ₹1,050. The company's leaders can add up the contribution of each pair sold and use it to pay the company's fixed costs, like rent and employee salaries. Once the company's leaders pay off their fixed costs, the product begins to make a profit, which they can use to expand the business.
Related: What Is Cost Of Production? (With Factors That Affect It)
Example Of This Calculation
Here is an example of this calculation for a small dress shop:
A dress shop's manager wants to calculate the profitability of the store's machine-made dress line. Each dress costs ₹900 to make, which is the variable cost, and costs customers ₹1,900 to purchase. The shop has fixed costs of ₹60,000 per month. To find the margin for each dress, the manager subtracts the variable cost from the product price and gets a result of ₹1,000. From this, the manager knows that the shop can meet its fixed expenses for the month and begin making a profit by selling at least 60 dresses.
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