Within the accounting files of every company are a list of terms and numbers that can be difficult to understand. To fully maximize the profits for your business, however, you need to ensure that you not only understand the terms, you understand how to correctly interpret the information that you can gather from them. Contribution margin deals with the cost of doing business – and what the products you sell contribute towards your profit.
A company has two costs: fixed and variable. The fixed costs are the costs that don’t change – rent, for example. Variable costs are the costs that change: materials, labor, etc. To determine the point at which your company makes a profit, you need to determine the contribution margin of your product.
Contribution margin is calculated by subtracting the variable costs of making a product from the revenue of selling it. The resulting amount is what is contributed towards your fixed costs. After your fixed costs are covered, the remaining margin is put towards your profit.
Need an example? Your company sells its goods for $30. To make them, it costs $23 in variable expenses – the materials, machinery costs, labor, etc. That leaves $7 per to put towards your fixed costs of $7000 a month – so the contribution margin is $7. To cover the fixed expenses, you would need to sell 1,000 a month to break-even. Any sales over the 1,000 adds $7 to your profit margin.
Using our example, if you wanted to increase your profit, decreasing your variable expenses to $20 per product would mean the contribution margin was $10. That would require you to only sell 700 before you covered your expenses. If you maintained your sales of 1,000 products a month, your profit would be $3,000. Conversely, if your contribution margin per product decreased to $3, it may be advisable to seek other products, or to increase the number of products sold.
Knowing how to understand the power of contribution margins can give insight into the profitability and feasibility of products within your company, and give clear direction about how to increase profits.