Are you struggling to meet fixed expenses? Wondering how many units to produce to achieve profitability?
Don't worry, you are not alone. Many businesses find it difficult to make a profit because they hardly have any money to invest in themselves and take their business to a higher level.
However, keeping an eye on your contribution margin helps determine areas that can be improved, leaving more additional funds to put into operations.
Whether you run a physical business or an eCommerce store, knowing how to calculate contribution margin is important.
In this blog, we’ll explain why contribution margin is so important to businesses, how it’s calculated, and how to improve operations to maximize profitability.
Woman holding a white book with 'Profit First' written on the cover
The contribution margin of a business is the amount left from sales after deducting the variable expenses related to that product. This amount can be used to meet fixed costs like rent, salaries, depreciation, etc.
The term "contribution" refers to the money that is contributed towards meeting the fixed expenses. Whereas, the term "margin" basically refers to the profitability.
Contribution margin is important for every business and should not be ignored, as it helps in long-term growth.
Assessing one's contribution margin helps with the following:
- Understand how many units to produce
- Set the right price for a product
- Eliminate product lines with low contribution margins
- Raise the money left after covering fixed costs
- Improvement in the financial condition of the business
Don't confuse contribution margin with profit margin. Profit margin is basically the ratio of net income to total sales. Contribution margin, on the other hand, is the amount obtained after subtracting all variable costs from revenue.
The contribution margin ratio, or CMR, is a financial metric used to measure the profitability of a business and helps to understand the profitability of a specific product line, or an entire company.
Here is the formula:
Contribution Margin Ratio = (Product Sales Revenue - Product Variable Cost) / Product Sales Revenue x 100
Let's look at a simple example: Suppose a business earned $100,000 by selling a product, and the variable expenses (or cost of goods sold) incurred to produce that product were $50,000, then the contribution margin ratio is:
($100,000 – $50,000) / ($100,000) x 100 = 50%
We can further explore why the CMR formula is important with this example:
A business has fixed costs of $500,000. They currently make a product that costs $10 per unit. The variable cost of the same product is $5 per unit.
Therefore the contribution margin ratio is 50%. This means that for every additional unit produced, $5 is contributed to cover fixed costs.
Now, we can calculate the quantity of products this business needs to produce through the following scenarios:
Scenario #1
The business currently produces 10 thousand units. This means that their contribution margin is:
$100,000 - $50,000 = $50,000
However, $50,000 is not enough to cover the fixed costs of $500,000, resulting in a net operating loss of -$450,000.
Therefore, this signals the business that it must increase production and make more units.
Scenario #2
The business now produces 100 units. This shows the contribution margin:
$1,000,000 - $500,000 = $500,000
In this scenario, $500,000 completely covers the fixed costs, resulting in a break-even point where total sales equal total costs. There is no profit or loss in this situation, but they must be corrected to make a profit.
Scenario #3
The business now produces more than 200 units. This means that their contribution margin is:
$2,000,000 - $1,000,000 = $1,000,000
The $1 million contribution easily covers the fixed costs of $500,000. In this case, the company has a net operating profit of +$500,000.
Through these examples, we can see how calculating contribution margin helps make effective business decisions. And while there is generally no "good" contribution margin, the higher it is, the better it is for a business's financial situation. In the next section, we'll look at tips to help improve a business's contribution margin.
Many businesses aim for a high contribution margin to maximize profits. However, in reality, there is no exact ratio or percentage because how much profit will be will depend on the specifics of the business.
Contribution margin helps in understanding the areas that need to be focused on to maximize profitability. Keeping this in mind, here are various ways to improve CMR:
Increase production volume
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As we have seen from the examples above, increasing the volume of goods sold helps spread the fixed costs over a larger number of units. As a result, this increases the contribution margin.
Businesses should focus on increasing demand and refining their production line, so that more units can be produced without significantly increasing variable expenses and contribution margin per unit.
Businesses can streamline their production process by reducing downtime, automating unnecessary tasks, minimizing wastage, improving inventory control, using better technology, etc.
Improve product sales
two men looking at a white laptop
Production volume alone does not guarantee sales, but sales are the fundamental pillar of every business, and businesses must constantly look for ways to increase product sales.
Higher sales directly help increase the contribution margin by generating more revenue while keeping fixed costs constant.
To improve sales, sellers should focus on strategies that increase demand for their product, use targeted marketing, improve the customer experience, or even introduce new product features and offers.
Cut down on overhead expenses
Cost cutting helps reduce costs and increase profitability. Businesses typically have a number of overhead expenses, such as administrative costs, office utilities, and corporate salaries, which are fixed costs.
Meanwhile, cost of goods sold (COGS) such as price of raw materials, supplier rates, electricity used, etc. are variable costs.
Businesses can reduce these expenses by outsourcing, renegotiating contracts, or optimizing office space, generating more revenue to cover fixed costs and contribute to profits.
Raise prices
Raising prices can also help increase the contribution margin, provided customers continue to purchase the products at the increased prices.
Selling products at higher prices raises revenue that can be used to cover fixed costs. However, this must be carefully balanced with market conditions and consumer value perception.
For example, if competitors sell the same product at a lower price, a price increase may reduce sales. Therefore, it is important to create a pricing strategy that justifies the increase in the eyes of consumers.
Assess product lines
Man calculating profitability using a Macbook
Evaluating different product categories can help determine which products have higher profit margins and which have lower ones.
For example, focus on promoting products with higher profit margins or developing new products with higher markups. This can significantly increase the contribution margin. Offering these products at a premium or bundling them with lower-margin products can also help maximize profitability.
In addition, selling more low-margin products can increase the total contribution margin. For example, selling a larger volume of low-margin products can help a business reduce its total fixed costs.
However, if a product line is not contributing to a healthy contribution margin, it may be better for businesses to eliminate it altogether so that they have more resources and money to invest in other areas.
The Bottom Line
Contribution margin not only helps in achieving profitability but also helps in detecting areas affecting the cash flow, such as dead stock, inefficient work processes, and over-priced suppliers, etc.
Contribution margin helps sellers and businesses evaluate their financial position and find ways to make better business decisions. So, be sure to evaluate your contribution margin today.
