When analyzing profitability and making business decisions the concept of contribution margin plays an important factor in optimizing production. Contribution margin is a helpful metric that analysts turn to when exploring marginal production cost and additional units of production.
While maximizing revenue is often viewed as one of the most important aspects of managing a business, some might argue that maximizing profitability is even more important.
This is because the cost of goods sold, or services provided, can sometimes outrun the revenue of the goods or services sold.
However, there is a wide range of applications for the concept, and understanding how to apply it can provide helpful insight into managing sales, expenses, and operations.
In this FAQ we will discuss what contribution margin is, why it is important to understand, and how to calculate and apply it.
What Is Contribution Margin?
The price of a single good or unit of service less all of the associated variable cost is a unit’s contribution margin. It is not to be confused with the net profit per unit, which would typically include allocation of fixed costs as well.
Contribution margin is a concept that is heavily relied upon because it demonstrates “left-over” revenue after accounting for variable costs. On the surface, this might seem inadequate for addressing profitability and that is because it is.
Contribution margin is not used when assessing profitability; instead, it is used when trying to understand the amount of revenue that remains after accounting for variable costs that can be used to cover fixed expenses and subsequently lead to potential profit.
Why Is Contribution Margin Important?
When businesses analyze how to price their products and services they rely heavily on contribution margin. In addition, sales professionals rely on it to determine the most efficient way to create commission structures.
The most common application of contribution margin occurs when analyzing and comparing different products and services that should be expanded or eliminated.
The practice of calculating contribution margin requires that accountants and analysts spend a great deal of time understanding what contributes to the variable costs of the businesses.
The process itself helps to shed light on where the organization is spending its money in the production of goods and services.
Contribution margin is helpful in that it highlights how much money per unit remains that can be allocated to fixed costs. In this way, it can be used to back into a budget for fixed cost.
For example, if one unit sells for $20 and the contribution margin is $10, then you know you have $10 for every unit sold that can be used to fund your fixed costs.
It is important to note that relying solely on contribution margin when making business decisions is short-sighted. Instead, it should be one of a variety of tools, costing methods, and financial analysis that is relied upon.
How To Calculate Contribution Margin And Apply It
Calculating contribution margin is simple, the challenge rests in understanding and peeling out variable cost per unit. There is more than one way that these costs can be identified and grouped. Once they are the formula is simple:
CM = Ri – VCi
- CM = Contribution Margin
- Ri = Product or service revenue per unit
- VCi = Variable cost per unit
The formula requires that you first have an understanding of the variable costs per unit. One way to do this is to perform what is known as marginal costing.
Marginal costing is a costing methodology that allocates direct labor, direct material, direct expenses, and variable expenses to each unit of production. It does not include fixed costs.
If there is only one product or service that contributes to revenue then you might be able to back into the variable costs using an income statement.
In this case, you would need to have some understanding of what expense line items contribute solely to fixed costs. This can be somewhat of a challenge and requires that some assumptions are made on what might be considered fixed versus variable.
For example, financing costs could be variable depending on how the debt is structured. Rent and administrative payroll are examples of income statement line items that are typically fixed.
Applying Contribution Margin
Once you have calculated the contribution margin it can be used for a variety of applications. One way it is used is to determine how many units need to be sold to cover fixed costs and therefore break even.
It is also commonly used when comparing two different products. If one product has a negative or lower contribution margin than another product it might make sense for a business to eliminate the lesser performing product and find ways to maximize sales of the better.
When the contribution margin is negative, it means that each unit produced results in a loss. When it is positive it means that it might be worth producing depending on your fixed costs.
Using DataRails to Calculate Contribution Margin
Every finance department knows how important it is to understand your company’s contribution margin. Regardless of the type of analytics you are performing, it requires big data to ensure accuracy, timely execution, and of course, monitoring.
By replacing spreadsheets with real-time data and integrating fragmented workbooks and data sources into one centralized location, you can work in the comfort of excel with the support of a much more sophisticated data management system behind you.
This takes financial planning and analysis from time-consuming to rewarding.