Definition: Contribution margin is the amount of money left over from sales after deducting the variable costs of producing goods or services. It shows how much money is available to cover fixed costs (like rent and salaries) and to make a profit.
Understanding contribution margin can help businesses (especially D2C e-commerce businesses) figure out how much money they are making from their products after covering certain costs.
In simpler terms, the contribution margin shows how much money is left over from sales after paying for the variable costs of producing a product. This leftover money, or margin, can then be used to pay for fixed costs like rent, utilities, or salaries, and to generate profit.
How to Calculate Contribution Margin
To calculate the contribution margin, you subtract the total variable costs from the total sales revenue. Here’s the formula:
Contribution Margin = Sales Revenue − Variable Costs
If a company sells a product for $100 and the variable cost to produce it is $60, the contribution margin is $40. This means that for each product sold, the company has $40 to cover fixed costs and profit.
Contribution margin per unit
You can also calculate the contribution margin per unit, which is the contribution margin for each product sold:
Contribution Margin per Unit= Selling Price per Unit − Variable Cost per Unit
This calculation helps businesses understand how much each product contributes to covering fixed costs and generating profit.
What are variable costs?
Variable costs are those costs that change with the level of production. Examples of variable costs include the cost of raw materials, packaging, and shipping.
These costs vary depending on how many units a company produces or sells. In contrast, fixed costs remain constant regardless of the level of production or sales, such as rent for a factory or salaries for employees.
It is important to differentiate between fixed and variable costs:
- Variable Costs: These are costs that change directly with the level of production or sales. Examples include materials, labor, and shipping costs. If a company produces more, its variable costs increase; if it produces less, its variable costs decrease.
- Fixed Costs: These are costs that remain constant regardless of production levels. Examples include rent, salaries, and insurance. Whether a company produces a lot or a little, its fixed costs stay the same.
Why Contribution Margin Matters
Contribution margin is important because it helps businesses figure out which products are the most profitable. For example, if a company sells two types of shoes, and Shoe A has a higher contribution margin than Shoe B, the company might decide to focus more on selling Shoe A to increase profits.
Businesses use the contribution margin to make decisions about budgeting and planning. It helps them understand how much money they have to work with after paying for the costs directly tied to making and selling their products.
Shaping your pricing strategy
Additionally, knowing the contribution margin helps businesses set prices. If a product has a low contribution margin, a company might decide to increase its price to improve profitability.
Alternatively, if a product is not selling well, the company could decide to lower its price to increase sales volume, provided the contribution margin remains positive.
Examples of Contribution Margin Analysis
For example, Nike, a leading brand in sportswear, might use contribution margin analysis to determine which products to market more aggressively. If Nike discovers that its running shoes have a higher contribution margin compared to its basketball shoes, it might focus more of its marketing efforts on running shoes to increase overall profits. This type of analysis helps companies focus on their most profitable products and maximize their revenue.
Implications of a high contribution margin
A high contribution margin indicates that a company has a higher amount of money available to cover its fixed costs and potentially earn a profit. Conversely, a low contribution margin might indicate that a company needs to reduce its variable costs or increase its selling prices to improve profitability.
Free Online Contribution Margin Calculators
Here are the top three online contribution margin calculators:
