Understanding contribution margin
Contribution margin is the difference between the sales price and variable cost per unit. So what is a contribution margin ratio? It's an example of a KPI that affects your business's financial health. It measures how profitable a particular product is for a company.
The contribution margin ratio is expressed as a percentage and takes into account variable costs that fluctuate with the units produced, which may include costs related to packaging, labor, and raw materials used in production.
This calculation doesn't include fixed costs but can tell you how much revenue remains for fixed costs. Using the contribution margin formula shows what percentage of revenue is left over after factoring in variable, fluctuating costs.
This number is typically used to help companies measure their profits and find ways to lower their variable costs. This calculation can also be used to determine prices for various products to ensure they earn enough revenue to make a profit on any sales. For instance, you can use this calculation to price your products based on current market conditions and variable and fixed costs.
Contribution margin sounds similar to profit margin, so confusing the two is easy. Your gross profit margin is the income you receive minus the cost of goods sold, including all fixed and variable costs like shipping and handling, production, and so forth. On the other hand, the contribution margin ratio subtracts variable costs from your sales.
Companies typically use this metric to determine how much revenue they generate by producing each additional unit after breaking even, measuring how much new sales contribute to their profits. The gross profit margin represents a company's total profits, while the contribution margin only refers to the earnings per unit. Typically, investors like to see a company's profit margin in their pitch deck, while the contribution margin ratio is used for internal business decision-making.
Determining your contribution margin per product or product line can ensure each unit is profitable and allow you to determine whether prices make sense in a competitive marketplace. This calculation can also help you decide whether or not it's worth it to continue selling a specific product or line while streamlining sales and operations. Ultimately, the key financial data you obtain is valuable for improving business decision-making.
How to calculate contribution margin ratio
It's fairly easy for any small business owner to calculate their contribution margin ratio. The CM ratio formula is as follows: