All day I’ve been thinking about contribution margin. I wish I could say that contribution margin was about the amount of good work we do divided by total work….like did I help anyone today? Did I contribute to a good cause? But no.
Contribution margin is the amount of variable costs like sales commissions, product marketing costs, and administrative support that will vary as sales go up or down. Contribution margin shows you the aggregate amount of revenue available after variable costs to cover fixed expenses and provide profit to the company.
Why do you care? Contribution margin will help you decide if you should add or subtract a product line, how to price a product or service and how to structure sales commissions. If a product’s contribution margin is negative, the company is losing money with each unit it produces, and it should either drop the product or increase prices. If a product has a positive contribution margin, it’s probably worth keeping.
Contribution margin =revenue – variable cost.
Calculating contribution margin gets tricky because we may be putting variable costs into fixed expenses. If we add a new product, we may need to add another customer service representative or it is a custom product and the rest of our line is standard so we need to add a designer. Those costs should be allocated to that product, not all products. We may need to price the product higher as a result.
We also need to know the contribution margin to calculate breakeven – the amount of sales we need minus the variable costs to cover our fixed costs.
Here is an example:
Let’s say your product sells for $100. Your variable costs (materials, hourly labor, commissions) are $60. Your fixed costs (rent, salaries, etc) are $2,000,000. You would need to sell 50,000 units to break even. 2,000,000/ (100-60).
Why even be thinking about this on a beautiful Sunday? Because our standard profit and loss statement doesn’t help most executives run a successful business. It was developed for accountants by accountants. Using better tools to analyze our businesses will help us be more successful. Calculating contribution margin focuses our whole team on the most profitable strategies and products. Try looking at your organization through this lens, and see if you need to reprice some products, or adjust some sales commissions. Let’s see if we can improve profitability this year by thinking smarter.