Contribution margin is a concept often used by managers to analyze product profitability. The formula is used to calculate the contribution margin of a single product P - V, where P is the cost of the product and V is its variable cost (the one associated with the resources used to make the object). In some cases, this value can also be referred to as a product's gross operating margin. This is a useful concept for discovering the amount of money a business can earn from the sale of a product to cover a fixed cost (which does not vary according to production) and generate profit.
Steps
Part 1 of 2: Finding the Contribution Margin of a Product
Step 1. Determine the price of the product
It is the first variable to know in order to calculate the contribution margin.
Let's continue with an example problem. Let's imagine you run a business that sells baseballs. If we sold them for € 3 each, 3€ it would be the price of a baseball.
Step 2. Determine the variable cost associated with the product
This is the only other variable we need to calculate the contribution margin. The variable costs associated with a product are those that change depending on the number of units made, such as salaries, costs for materials, energy and water bills, etc. The greater the number of units produced, the higher these costs - they are called variable costs because of their changing nature.
- In our example of the company that makes baseballs, imagine that the total cost of the rubber and leather used to build the balls over the past month is $ 1,500. In addition, employee salary expenses were € 2400 and company bills cost € 100, for a total of € 4000 of variable costs. If the company produced 2,000 baseballs that month, the variable cost of each ball is (4000/2000) = 2, 00€.
- Note that, in contrast to variable costs, fixed costs are those that do not change according to the volume of production. For example, the rent paid by the company for the use of the building is the same regardless of the number of baseballs produced. This is why it is included in the fixed costs, which are not included in the calculation of the contribution margin. Other common fixed costs are expenses for buildings, equipment, patents, etc.
- Bills can be included in both fixed and variable costs. For example, the amount of electricity a store consumes during its opening hours is the same regardless of the number of units sold. In a manufacturing plant, on the other hand, the consumption of electricity can vary depending on the number of units produced. Determine if some of the bills fall into the variable cost category for your case.
Step 3. Subtract the unit variable cost from the unit price
When you know both of those values, you are ready to calculate the contribution margin with a simple subtraction: price - variable cost. The value obtained represents the amount of money from the sale of a single product that the company can use to pay fixed costs and generate profit.
- In our example, it is easy to find the contribution margin of each ball. Simply subtract the unit variable cost ($ 2) from the price ($ 3) to get (3 - 2) = 1€.
- Note that, in real applications, the contribution margin is an entry that can be found on the income statement of a company, a document published for investors and the taxman.
Step 4. Use the contribution margin to cover fixed costs
A positive contribution margin is always a desired result: the product recovers its variable cost and contributes (hence the name of the value) for a certain amount to the payment of the fixed costs. Since fixed costs do not increase with the quantity of production, once they have been covered, the contribution margin of the remaining products sold is transformed into pure profit.
In our example, each baseball has a contribution margin of $ 1. If the rent for the company building is $ 1,500 per month and there are no other fixed costs, you need to sell 1,500 baseballs per month to cover the fixed costs. Beyond that amount, each baseball sold generates $ 1 in profit
Part 2 of 2: Using the Contribution Margin
Step 1. Find the relationship between contribution margin and price
Once you have found the contribution margin for a product, you can use this value to carry out some simple financial analysis tasks. For example, you can find the percentage contribution margin, a relative value, by simply dividing the result obtained above by the price of the product. This information represents the portion of each sale that makes up the contribution margin; in other words, the part used to pay fixed costs and generate profit.
- In the example above, a baseball's contribution margin was $ 1 and the selling price $ 3. In this case, the percentage contribution margin is 1/3 = 0, 33 = 33%. 33% of each sale allows you to pay fixed costs and generate profit.
- Note that you can find the contribution margin for multiple products by dividing the total contribution margin by their total sales price.
Step 2. Use the contribution margin for a quick balanced budget analysis
In simplified financial scenarios, if you know the contribution margin of a company's product and the fixed costs it has to incur, you can quickly calculate whether the company generates profit. Assuming that the company is not selling its products at a loss, to generate profit it only needs to sell enough units to cover fixed costs; the price of the products is already higher than the share of variable costs; if the company sells enough products to cover fixed costs, each additional sale generates a profit.
For example, let's assume that our baseballs manufacturing company faces fixed costs of $ 2,000 and no more than $ 1,500 as mentioned earlier. If we sold the same number of balls, the revenue would be € 1.00 × 1500 = € 1500. This value is not enough to cover the 2000 € of fixed costs, so the company has the balance sheet in red.
Step 3. Use the contribution margin (even in its percentage form) to criticize a business plan
This value can be used to make decisions about the management of a company, particularly if it is not generating a profit. In this case, you can use the contribution margin to create new sales goals or to find ways to reduce fixed or variable costs.
- For example, the value can be used to identify the expense items that need to be reduced. Imagine that you are tasked with correcting the $ 500 budget gap in the previous example problem. In that case, there are several options. The contribution margin of each baseball is $ 1, so you could just try to sell 500 more balls. Alternatively, you can try moving the manufacturing location to a building with a lower rent, reducing fixed costs, or even using less expensive materials to lower variable costs.
- For example, if you could reduce the production costs of each baseball by € 0.50, the profit would be € 1.50 per ball instead of € 1, so the revenue from the sale of 1500 balls would come to 2250€, generating a profit.
Step 4. Use the contribution margin to prioritize the most profitable products
If your company sells more than one product, their contribution margin can help you decide how many quantities of each to create. This is especially important if the products use the same raw materials or manufacturing processes. In those cases, you need to prioritize one product, so you should choose the one with the highest contribution margin.
- For example, let's assume the company produces soccer balls as well as baseballs. Soccer balls have higher variable costs (€ 4), but are sold at a price of € 8, offering a higher contribution margin: 8 - 4 = 4 €. If soccer balls and baseballs are made of the same type of leather, then you should definitely prioritize football balls, which get four times the $ 1 contribution margin of baseballs.
- The most important aspect is that in this case the soccer balls offer a percentage contribution margin of 0.5 compared to that of baseballs of 0.33. This means they are more efficient at producing profit for the company.
