This magical number helps you figure out which products are making you money and which ones are just draining your resources.
We’ll show you how to calculate it, why it’s super important, and how you can use it to make smarter business moves. Plus, we’ll share our top tips to help you boost your profits even more. So, whether you’re a seasoned retail or hospitality business owner or just curious about making more money, this guide is for you.
Let’s get started.
What is the contribution margin?
A company’s contribution margin is the money left over from sales after paying all the variable costs to make a product. Think of it as the extra cash you get from selling your brilliant products once you’ve covered all the costs that change with production.
Once you subtract your business’ fixed costs from your contribution margin, you get your net income or profit. It’s like peeling away the layers to get to the sweet, juicy profit center.
Now, let’s get into what variable costs and fixed costs really mean.
Variable costs
Variable costs depend on how much stuff you make or sell, or any expense which could be different from one month to the next. The more you produce, the higher these costs go. Think of a factory that needs raw materials to produce products. If they make more products one month, they need more raw materials. Those raw materials are a variable cost.
Another example? A cafe owner needs coffee, pastries, and other goodies to sell. The more customers they have, the more supplies they’ll need. So, the cost of these supplies goes up as sales go up. These variable costs are really crucial when calculating the contribution margin because they directly impact how much money you actually get to keep.
Fixed costs
Now let’s cover fixed costs. Your company’s fixed costs (also known as your fixed expenses, FYI) are the expenses that stay the same no matter how much you produce or sell. They’re the costs of simply existing as a business. For example, buying machinery is a one-time fixed cost. Whether you use it a lot or a little, the cost remains the same. But as you sell more units thanks to the machinery, that fixed cost becomes a smaller percentage of each unit’s cost when you calculate your profit margin.
Another common fixed cost is rent for your business space. Whether you sell a ton of goods or just a few, the rent stays the same every month. These fixed costs are often considered sunk costs, meaning once you’ve spent the money, you can’t get it back. When you’re making decisions about costs or profitability, you generally don’t factor these in because they don’t change with your level of production.
How to calculate contribution margin
Now that you’ve got a good grasp on what contribution margin is and why it matters, let’s learn how it’s calculated. Understanding how to crunch these numbers will give you a clear picture of your product’s profitability.
Contribution margin formula
Here’s how you figure out the contribution margin: you take all the money you make from selling your product and subtract the costs that change with how much you sell. These costs are called variable costs. So, the contribution margin formula looks like this:
Contribution Margin (C) = Total Sales Revenue (R) – Variable Costs (V)
This formula tells you how much each product sale contributes towards covering your fixed costs and making profit. It’s like seeing the real cash you’re making after all the costs that change with production are taken care of.
Contribution margin calculation example
Let’s break it down with an example. Say you sell one of your awesome products for $50 each, and it costs you $20 in variable costs (like materials and direct labor) per unit:
Contribution Margin = $50 – $20 = $30 per unit
So, for each product you sell, $30 goes towards covering your fixed costs and making profit. If you sell 1,000 units, that’s $30,000 in total contribution margin ($30 × 1,000 units).
Contribution margin ratio
Now, the contribution margin ratio tells you how much of each dollar from sales becomes profit after covering variable costs. It’s a handy percentage to know because it shows how efficient your business is at turning sales into money you keep.
Take a look at the contribution margin ratio formula:
Contribution Margin Ratio (CR) = (Contribution Margin (C) / Total Revenue (R)) × 100%
The closer this ratio is to 100%, the better. A higher ratio means more money is left to cover your business’s fixed costs. But realistically, this ratio is often less than 50%. That’s okay though, it’s still valuable for understanding your profitability.
This ratio helps you see if your products are making enough profit. If it’s too low, it might not be worth selling that product at its current price. By figuring this out, you can decide whether to keep making and selling it or focus on products that bring in more profit.
CM ratio calculation example
Let’s see how it works in action. Say your total sales revenue (R) for a product is $100,000, and your variable costs (V) associated with that product amount to $60,000:
First you’re going to want to calculate the Contribution Margin.
$100,000 – $60,000 = $40,000
Now, you just need to work out the Contribution Margin Ratio (CR):
($40,000 / $100,000) × 100% Contribution Margin Ratio (CR) = 40%
In this example, the contribution margin ratio is 40%. This means that for every dollar of sales revenue, 40 cents contribute towards covering fixed costs and generating profit.