Sound investing and successful businesses depend on data to make decisions. Having sales determines if there is a demand for a product. However, the contribution margin determines if a product is profitable, which anyone can easily calculate with the contribution margin formula.
I’m a big fan of Shark Tank and love how the sharks throw rapid-fire questions to business owners, especially about their numbers. They always ask these questions:
- What are your sales?
- How much do you sell it for?
- How much does it cost you to make it?
Whether they love or hate a product or business, they can’t argue with the numbers. And, whether you love them or hate them, they are right!
So, before you start bragging about your sales on the income statement, it’s essential to understand your margins. Which product should you focus your energy on? Or, which product should you altogether remove?
What is Contribution Margin?
Contribution margin definition is the difference between revenue and variable costs (sales revenue – variable costs).
This definition is different from net income, which takes into account net sales, variable costs, and fixed costs. Thus, the difference between revenue and the sum of variable costs and the company’s fixed costs is the net income.
Thus, the overall contribution margin only focuses on the variable costs associated with producing a product.
What are Fixed Costs?
Fixed costs are expenses that do not fluctuate in prices or are a one-time-only expense. Also, the fixed costs do not directly impact the number of products or units sold.
So, although these expenses affect the net operating income, they are not accounted for when determining the contribution margin.
For example, fixed costs include the rent associated with leasing a commercial space, will be consistent every month. A commercial space tenant can agree with the utility company where they pay a “locked-in” price. As a result, their utility bill will be consistent regardless of how much electricity or water the tenant uses.
Additionally, paying an employee a salary is also a fixed cost because it can regularly pay them the same amount.
An example of a one-time-only expense is the equipment used to produce a product or perform a job. For example, a restaurant owner purchased stoves and ovens for their restaurant. The owner will not be buying a stove or oven regularly.
What are Variable Costs?
As the name implies, variable costs include expenses that can fluctuate in prices, not necessarily consistent. The following variable costs are some examples.
The most common variable cost is the cost of raw materials. Referencing the restaurant example, the selling price for ingredients, such as produce, meats, etc., can vary depending on the season or the demand. So, although the equipment used to prepare the food is a fixed cost, the food that a chef produces is a variable cost.
Another example of a variable cost is paying an employee a commission versus a salary pay. The amount of commission an employee receives varies on how many sales they make. Furthermore, employers can structure sales commissions to have less variable costs.
In both examples, these variable costs have an impact on the number of units sold.
How Important is a Contribution Margin?
A business owner who understands their company’s contribution margin is one way they help their company become successful. Although having various products may sound nice, producing products that don’t generate cash flow can cause a company to bleed money and file for bankruptcy.
For this reason, every business owner needs to understand the numbers in the contribution margin income statement. Then, they need to make decisions from this data.
According to the numbers or contribution margin analysis, an owner can subtract a product line if it has a low contribution margin implying it is not performing well. Or, they can decide to promote another product that can generate a high contribution margin.
Business and investing are always about the numbers and not about speculating. Investors also can use the product’s contribution margin to determine if they want to invest in a company continually.
For example, a company that plans to focus energy on a poor-performing product that does not have a positive contribution margin can cause investors’ concern.
Contribution Margin Formula
The total sales revenue and variable costs are the main contribution margin formula components. Therefore, subtracting the total variable costs from the revenue will calculate a contribution margin.
Contribution Margin = Net Sales Revenue minus Total Variable Cost
For a contribution margin example, a fictional company called Jalapeno Business sells various snacks with jalapeno flavors, such as chips, crackers, and lollipops. He rents out commercial space to produce these items.
Below is the breakdown of the revenue, variable expenses, and the total contribution margin income for each snack in the jalapeno product line:
|Variable Costs (VC)
(R - VC)
According to the table above, the jalapeno lollipops have the highest revenue. However, after applying the contribution margin calculation, the jalapeno chips have the highest contribution margin.
The business can use the margin to cover the fixed expenses, such as taxes, insurance, utilities. After the company pays for all costs, anything left over is net income or net profit.
What is Contribution Margin Per Unit?
If a business wants to track a particular product’s performance, it can calculate the contribution margin per unit. This metric reveals how much of a margin each sale makes.
In contrast, the contribution margin formula alone uses the revenue and variable costs for all sales for an individual product. Thus, although two different products may generate the same income, the number of units sold may vary. Furthermore, the per unit variable costs remain constant.
In an earlier example, the chips and crackers both generated $20,000 in sales. However, one product may have required more units sold to equate to the same revenue.
Contribution Margin Per Unit Formula
The contribution margin per unit is calculated by taking the difference between the revenue and the variable costs and dividing it by the number of units sold. In other words, it’s the contribution margin divided by the number of units sold.
Contribution Margin Per Unit Formula = Contribution Margin / Number of units soldFor example, continuing with the jalapeno snacks theme took 2,000 units of jalapeno chips to generate $20,000, while it took 4,000 units of jalapeno crackers to generate the same amount.
|Variable Costs (VC)
|Number of units sold
|Contribution Margin per unit
(CM / N)
From the table above, though the chips and crackers generate the same revenue, the chips perform better than both the jalapeno crackers and lollipops. These numbers imply that it may be worthwhile to focus more energy on selling more chips or discontinue producing the crackers.
Contribution Margin Ratio Formula
Alternatively, a business can calculate the contribution margin ratio, which removes the dollar amount when comparing products and ignores sales volume. This ratio is also called the profit volume ratio.
The contribution margin ratio is calculated by dividing the contribution margin per unit by the sales price per unit:
Contribution Margin Ratio Formula = Contribution Margin Per Unit / Sales Price Per Unit
For instance, the chips sell for $5.00, the crackers sell for $6.00, and the lollipops sell for $3.00. Below is the table with the breakdown of the contribution margin ratios regarding each sale price.
|Contribution Margin per unit
|Contribution Margin Ratio
(CMPU / S)
Therefore, for every $1.00 of revenue for jalapeno chips, the contribution margin is $1.00. Whereas, for every $1.00 of income for the jalapeno crackers, the contribution margin is about $0.21. Once again, the data shows where the business can focus its energy.
What is a “Break Even Point”?
The “break even point” is the number of units a company needs to sell to cover fixed costs. Otherwise, the product would have a negative net profit leading to a negative contribution margin. The break-even point is calculated by dividing a company’s fixed costs by the per-unit contribution margin:
Break Even Formula = Total Fixed Cost / Contribution Margin Per Unit
For example, the fixed cost for producing jalapeno crackers is $12,500. With a per unit contribution margin of $1.25, according to the break-even analysis, the company needs to sell 10,000 units of jalapeno crackers to break-even.
Contribution Margin Calculator
Below is a super simple contribution margin calculator. Once you provide the required fields, you can calculate the contribution margin, contribution margin per unit, and contribution margin ratio.
If you’re ready to swim with the sharks, then you better know your numbers and understand how the contribution margin works!
When investors ask what your total sales are, they want to see if there is a demand. However, when they ask for the price per unit sold and the cost to make it, they try to determine its profitability.
Although variety is the spice of life, achieving success can be tedious. Therefore, business owners should work on their business rather than in their business. They accomplish this approach by developing simple systems that provide repeatable results.
Business owners can set aside emotions from data-driven decisions with the help of data calculated by the contribution margin formula and additional financial analysis. This way of thinking has led to the success of many products made in America.