In an ideal world, all of your sales would contribute 100% of their value to your bottom line. Unfortunately, that's not the case. Your sales are affected by every employee's commission, shipping charges, equipment fees, and other expenses.
For this reason, you should get familiar with an accounting concept called the contribution margin. If you have a startup or have been a CFO for years, you've probably heard the term before. But what is a contribution margin, and why should you care?
The contribution margin tells you how much money is leftover from each sale after deducting production costs. Put another way, it shows you how much a single sale actually contributes to your revenue.
Here's a look at how to calculate the contribution margin, why it's important, and what it can tell you about your business.
What Is a Contribution Margin?
The contribution margin is a measurement of how much money your company makes with each sale after subtracting the variable cost of the item sold. You can express a contribution margin in percentages or ratios.
Calculating this margin helps companies know how much money is available to pay fixed costs, like salaries, rent, or utilities.
There are two types of contribution margins to look at:
- Variable Contribution Margin — The variable contribution margin is the difference between revenue and variable production costs. If your variable contribution margin is lower than the price you've set for a product, you won't make any money on that sale.
- Annual Contribution Margin —You can calculate the annual contribution by deducting all sales from the annual expenditure. These expenses include things like operating costs and finance costs. If there’s a negative annual contribution margin, the company loses money with every sale.
How to Calculate Contribution Margin
You can get your contribution margin by subtracting the variable costs per unit from the selling price. Let’s work through a quick example to illustrate how this works.
Say you have a business that makes cookies at home and sells them at a local farmers' market. You buy the ingredients for your cookie recipe for $1.50/cookie. At the market, you charge $3.00/cookie.
You'd subtract the cost of the ingredients from your revenue. This means your dollar contribution per unit is $1.50.
To convert your contribution margin to a percentage, subtract your product's variable costs from its total revenue. Then, divide the difference by the product's total revenue. Following that, multiply your answer by 100.
What Are Variable Costs?
Variable costs are those expenses that change in proportion to the number of products produced. They tend to be things like materials, labor, and shipping—things that can adjust. Variable costs are also called "direct costs" to reflect their relationship to the products.
Here’s an example to help you understand variable costs a little more: if you're a baker and bake ten loaves of bread with two pounds of flour each, you'll use 20 pounds of flour for that batch. If the current price of flour is $2 per pound, then the variable cost for that batch will be $40.
What Are Fixed Costs?
The opposite of a variable cost is a fixed cost, which is a cost that remains constant no matter how many products you sell. Fixed costs can include rent, insurance, taxes, salaries for management personnel, etc.
You’ll need to know your fixed costs, so you don’t miscalculate your contribution margin.
What Is Considered a Good Contribution Margin?
The closer a contribution margin is to 100%, the better. It means that the business has more money available to cover its expenses.
In addition to calculating the contribution margin ratio at an overall level, you should also calculate it for specific products. If you notice a product with a low contribution margin, it's not bringing in enough money to be worth keeping.
If you have products with a high contribution margin, you could look into ways to invest in these products. You could add more features, increase advertising, and work to increase sales volume so that they contribute even more to your bottom line.
What Is a Contribution Margin Income Statement?
A contribution margin income statement takes all of a company's variable expenses and subtracts them from its sales. The fixed expenses are then taken out of this amount to get the net profit.
This type of income statement takes variable expenses into account, so it helps you understand why your business makes or loses money. That way, when you're looking at your net profit or loss, you'll be able to tell where it's coming from—whether it's due to changes in market prices, sales volume fluctuations, or something else entirely. That makes it much easier to decide what direction your company should take next.
What Is a Contribution Margin Analysis?
A contribution margin analysis looks at the money left after deducting variable expenses from revenues. You can use this analysis to compare the revenue from products and services, so that management can decide which ones to sell and which to drop.
You can use this same analysis to see if a company is worth buying. If it's not, you can try negotiating the costs of the target entity to generate more profit.
See Also: What is Financial Reporting and Why It Is Essential For Startups
Understand Your Profits With the Help of a Finance Team
Hopefully, you've gotten helpful answers to your question, “what is a contribution margin” and now also know how to calculate it for your business.
But it's easy to make a mistake when determining your business's contribution margin if you don't have the proper accounting experience. Those mistakes could skew your numbers and paint an unclear picture of your business's financial health.
To stay on track, get help from Zeni. Work with us to calculate your contribution margin correctly and make sure you have a clear understanding of all your expenses so that you can make informed decisions about your business.