Summary: Determining the contribution margin of a product you sell can be a difficult undertaking, but it can assist with product pricing and strategic prioritization as well as assist in calculating your business’s break-even point. However, it’s important to understand other benefits to products with low contribution margins before you drop them.
When you want to calculate the financial health of your business and understand your profitability, you have a lot of options at your disposal: profit margin, gross profit, operating profit, net profit, and contribution margin. All of these calculations offer insight into different aspects of your business’s profitability at different levels. Contribution margins, which we’ll discuss here, help you understand how a specific product contributes to your company’s profit.
You Should Know How To Calculate Contribution Margins
In order to understand how each of your products is contributing to your business’s profit so you can determine what to keep, scale up, or get rid of for maximum profitability, you need to be able to determine that product’s contribution margin. Similarly, contribution margins can be used as part of a strategy to effectively to price products. Put simply, a product’s contribution margin is as follows:
Contribution Margin = Revenue - Variable Costs
There’s also a related calculation, the contribution margin ratio which looks like this:
(Total Sales Revenue - Variable Costs To The Business) / Total Sales Revenue
The contribution margin ratio expressed as a percent, it is the portion of total sales revenue that became profit after deducting the cost to develop each individual product sold.
While the equations appear straightforward at the surface, calculating contribution margins can actually be difficult and time-consuming, especially for businesses who have expenses that fall somewhere between variable and fixed, such as adding machinery to increase production or salaries that also include commissions.
Why Contribution Margins Matter To Your Business Success
The contribution margin is an important factor in determining your business’s break-even point. Here’s how they fit together:
Break-Even Point = Total Fixed Expenses ÷ Contribution Margin Ratio
Together, these figures can offer insight into your company’s overall operational efficiency, a factor vital to business success.
Contribution margin should not be the sole deciding factor in whether or not to continue a product or product line. On the surface, a product with a low contribution margin may seem like an obvious item to stop producing, but that item is still contributing to fixed costs and profits.
Low-contribution margin items can actually be of great benefit to your business, especially if they are what is considered a “cash cow.” Cash cows are products that provide reliable income and often require very little support, R&D, or sales pressure and may serve as a barrier to entry for competitors. Because these products often have high variable costs but use little in fixed costs, they will have a low contribution margin, despite notable benefits to the company. Even products that appear to be negatively profitable by conventional assessments may have a positive contribution margin and, therefore, be worthwhile to keep producing.
However, if a product has a negative contribution margin, then a company is losing money with each sale. A negative contribution margin is a strong indicator to increase prices or stop making a certain product.
Pros and Cons Of Contribution Margins
Contribution margins are easy to use in the sense that you follow a short calculation based on information you already have. These calculations can be used for pricing, product strategy, and even contingency analysis. Using contribution margins, with an understanding of their break-even point, companies can determine if a product will be profitable in the near future. It can also help companies achieve optimal production levels in order to meet their financial goals.
Contribution margins have downsides. This calculation ignores the fact that demand fluctuates, as do price and cost. This makes CM viable for short-term analysis only. Other downsides to contribution margins include the fact that they do not account for selling costs - only production costs - and only one product is able to be analyzed at once with a flawed assumption of limitless profits.
However, contribution margins are still a valuable tool to have in any business leader’s arsenal. Contribution margins can help wise business leaders better understand how each product supports their revenue growth in order to determine where to focus their efforts. In short, contribution margins assist with pricing and prioritization, two critical factors in business success.