A contribution margin measures how profitable a product is to produce. A company’s contribution margin shows how much revenue is available after it deducts variable costs like raw materials and transportation expenses. For a product to be profitable, the remaining revenue after variable costs needs to be higher than the company’s fixed costs, like insurance and salaries.
In this guide, we’ll go over:
- Contribution Margin Definition
- How to Calculate Contribution Margin
- Gross Profit Margin vs. Contribution Margin
- How to Show Contribution Margin Skills on a Resume
- Similar Accounting Skills
Contribution Margin Definition
Contribution margin explains how growth in sales can affect growth in profits. To calculate the margin, you subtract variable costs (like shipping expenses) from sales revenue — the remaining amount of revenue covers fixed expenses (like rent). Any revenue left after fixed expenses is profit or earnings.
A business’s contribution margin can be shown as a dollar amount or a ratio, depending on the formula. You can also use the formula to look at margins for the company as a whole, specific product lines, or individual units of product.
Who Uses Contribution Margins?
Business owners, finance teams, and accountants may rely on contribution margins to make a variety of business decisions. For example, companies can determine which products are profitable and which should be discontinued by understanding the contribution margins for each product line. Also, this margin is an important factor in price setting — the contribution margin needs to be high enough to cover fixed expenses and ideally high enough to generate profits.
>>MORE: Learn what it’s like to run your own business with the Chartered Accountant ANZ Accounting and Business Performance Virtual Experience Program.
How to Calculate Contribution Margin
Contribution Margin Formula
The main formula used to calculate contribution margins is:
Contribution Margin = Sales Revenue – Variable Costs
There are some alternative formulas you can use, though. For example, if you want to look at the contribution margin per unit of product, the formula would be:
Contribution Margin Per Unit = Price Per Unit – Variable Cost Per Unit
Additionally, you can find contribution margins using fixed costs instead of variable costs using this formula:
Contribution Margin = Fixed Costs + Net Income
Components of the Formulas
Sales, net sales, or revenue are all common names for the money brought into a company through the sale of goods or services.
Variable costs are expenses associated with producing goods or services that fluctuate depending on production volume, suppliers, and labor. Typically, more production means higher variable costs. Some common variable costs include:
- Raw materials for production
- Machinery maintenance costs
- Employee hourly wages and labor expenses that vary with production volume
- Commission paid to salespersons
- Shipping, freight, and transportation costs
- Utility expenses related to production
Fixed costs are expenses that stay constant regardless of if production flows change — even if production shuts down for a few weeks, the company still needs to pay for these expenses. Some examples of fixed costs include:
- Salaries that are constant regardless of changes in production volume
- Rent or mortgages
- Interest payments
- Insurance expenses
- Property taxes
Net income is sales revenue minus the cost of goods sold (COGS), business expenses (like rent, marketing, and advertising), interest costs, and taxes. As a business metric, net income measures profitability and determines how much a company’s revenue exceeds its expenses.
Contribution Margin Ratio
The contribution margin is closely related to the contribution margin ratio. This ratio shows what percentage of the company’s revenue is contribution dollars or how much is available to cover fixed expenses.
The formula for calculating the contribution margin ratio is:
Contribution Margin Ratio = (Sales Revenue – Variable Costs) / Sales Revenue
>>MORE: See how expenses, profits, and losses can affect a business with JPMorgan’s Global Finance and Business Management Virtual Experience Program.
Let’s imagine a company that sells wireless headphones. The company has the following business expenses per unit of production:
|– Speaker components||$1.15|
|– Battery parts||$2.05|
|– Plastic housing||$0.05|
|Machinery maintenance costs||$0.03|
|Employee wages and labor expenses||$1.05|
|Shipping, freight, and transportation costs||$1.50|
|Utility expenses related to production||$0.27|
|Sales revenue (sales price per product)||$65|
First, we need to find the total for the variable costs. Adding transportation expenses, wages, raw materials, machinery maintenance, and utilities, we get $6.10, which means that it costs the company $6.10 in variable expenses to produce one pair of wireless headphones.
Next, we can use the contribution margin formula:
$65 (sales revenue per unit) – $6.10 (variable costs per unit) =
$58.90 (contribution margin per unit)
For every pair of wireless headphones sold, the company makes $58.90, which it will use to cover fixed costs and, ideally, gain a profit. Another way to look at this is to consider the contribution margin ratio, though.
[$65 (sales revenue per unit) – $6.10 (variable costs per unit)] / $65 (sales revenue per unit) =
90% (contribution margin ratio per unit)
This means that 90% of the total sales revenue from each unit sold is available to cover fixed costs.
Interpreting the Results
The more revenue available after variable costs are covered, the better, especially considering how expensive fixed expenses like rent and salaries can be. At the very least, a product must have a positive contribution margin to be worth producing. So, even if the product isn’t that profitable, the company can break even as long as the margin is high enough to cover fixed expenses. Additionally, companies can improve contribution margins by adjusting production costs and making processes more efficient.
On the other hand, products with negative contribution margins ultimately harm a business with every unit of production. They cost the company significantly more to produce than they generate in revenue.
Gross Profit Margin vs. Contribution Margin
Contribution margins are sometimes confused with profit margins because both measure profitability. However, contribution margin removes variable costs from the result, leaving only the amount of revenue available for fixed expenses.
Gross profit margin, on the other hand, looks at the cost of goods sold (COGS), which includes both fixed and variable costs. Ultimately, gross profit margin is a measure of the overall company’s profitability rather than an analysis of an individual product’s profitability.
>>MORE: Learn more about profit margins.
How to Show Contribution Margin Skills on a Resume
There are two key areas on your resume where you can showcase your skills and understanding of contribution margins.
First, in a job or internship description, you can describe an instance where you needed to calculate contribution margins and how your efforts impacted the company as a whole. For example, you could mention if you found that one product line was underperforming and had a negative contribution margin and that your suggestion to discontinue production saved the company money.
You can also mention contribution margin in the skills section of your resume. Since contribution margins are one way to measure profitability, you could list that you are skilled in measuring profitability using various methods, such as contribution and profit margins.
>>MORE: Check out more accounting skills you need on your resume.
Similar Accounting Skills
Calculating and using contribution margins is a vital skill for accounting, finance, and business careers. Other crucial skills to have include:
- Knowing how to do business valuations, like discounted cash flow (DCF) analysis
- Understanding how to calculate net working capital
- Using the current ratio and quick ratio to check a company’s financial health
Explore more skills with Forage’s finance virtual experience programs.
Image credit: Canva