Struggling to cover fixed expenses? Wondering how many units to produce to attain profitability?
Don’t worry, you’re not alone. Many businesses struggle to achieve profitability because they rarely have any money to invest in themselves and scale their business to a higher level.
However, keeping an eye on one’s contribution margin helps to determine areas that can be improved, leaving more spare money to put back into operations.
Whether you run a brick-and-mortar business or an e-commerce store, the importance of knowing how to calculate contribution margin cannot be overemphasized.
In this blog, we’ll cover why contribution margin is so integral to businesses, how to calculate it, and how to fine-tune operations to maximize profitability.
Table of Contents
● What is contribution margin, and why is it so important?
● How to calculate the contribution margin ratio
● Tips to improve contribution margin to maximize profitability
● Bottom line
What is contribution margin, and why is it so important?
A business’s contribution margin simply refers to the money that remains from sales after subtracting the variable expenses related to that product. This money can then be used to cover fixed costs such as rent, salaries, depreciation, etc.
The word “contribution” refers to the money that contributes towards covering fixed expenses. Whereas, the word “margin” basically denotes profitability.
Contribution margins are important to every business and shouldn’t be overlooked, as they help in long-term growth.
Assessing one’s contribution margin helps to:
- Understand how many units to produce
- Establish the right price for a product
- Eliminate product lines with lower contribution margin
- Increase the money left over after covering fixed costs
- Improve the financial position of the business
Contribution margin shouldn’t be confused with profit margin. Profit margin is basically a ratio of net income to total sales. On the other hand, contribution margin is the revenue minus all variable costs.
How to calculate the contribution margin ratio
Contribution margin ratio, or CMR, is a financial metric used to measure the profitability of a business and helps to understand a specific product line, or the entire company’s, profitability.
Here is the formula:
Contribution margin ratio = (Product sales revenue – Product variable costs) / Product sales revenue x 100
Let’s look at a simple example: Suppose a business has earned $100,000 from selling a product, and variable expenses incurred to produce that product (or the cost of goods sold) 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 to cover. They currently produce a product that costs $10 per unit. The variable cost for the same is $5 per unit.
The contribution margin ratio is therefore 50%. That means for every incremental unit produced, $5 is contributed toward covering fixed costs.
Now, we can calculate the volume of products this business needs to produce via the following scenarios:
Scenario #1
The business currently produces 10k units. This means their contribution margin is:
$100,000 – $50,000 = $50,000
However, $50,000 is not sufficient to cover the fixed costs of $500,000, resulting in a net operating loss of -$450,000.
Therefore, this indicates to the business that it must step up production a produce more units.
Scenario #2
The business now produces 100k units. This shows a contribution margin of:
$1,000,000 – $500,000 = $500,000
In this scenario, $500,000 covers the fixed costs exactly, resulting in a breakeven point, where total sales equal total costs. There is no profit or loss in this circumstance, but they must improve in order to make a profit.
Scenario #3
The business now produces over 200k units. This means their contribution margin is:
$2,000,000 – $1,000,000 = $1,000,000
A $1 million contribution easily covers the fixed costs of $500,000. In this situation, the company incurs a net operating profit of +$500,000.
Via these examples, we can see how calculating contribution margin assists in making effective business decisions. And while there is no “good” contribution margin in general, the higher it is, the better it is for the business’s financial health. In the next section, we’ll look at tips to help improve a business’s contribution margin.
Tips to improve contribution margin to maximize profitability
Many businesses aim for a higher contribution margin to maximize profitability. In reality, however, there is no perfect ratio or percentage because what is profitable will depend on the specifics of the business itself.
Contribution margin helps to understand areas that need to be focused on in order to maximize profitability. With that in mind, here are various ways to improve CMR:
Increase production volume
As we have seen from the above examples, increasing the volume of goods sold helps to spread 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 to produce more units without significantly increasing variable expenses and the per-unit contribution margin.
Businesses can streamline their production process by reducing downtime, automating redundant tasks, minimizing wastage, improving inventory control, using better technology, and so on.
Improve product sales
Production volume alone doesn’t guarantee sales, but sales are the bloodline of every business, and businesses should constantly look for ways to increase product sales.
More sales help directly boost contribution margin by generating more revenue while keeping fixed costs steady.
To improve sales, sellers should focus on strategies that increase demand for their product, use targeted marketing, improve customer experience, or even introduce new product features and offers.
Cut overhead expenses
Cost cutting helps to decrease costs and improve profitability. Businesses usually incur a range of overhead expenses, such as administrative costs, office utilities, and corporate salaries, which are fixed costs.
Meanwhile, the cost of goods sold (COGS) like the 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 to free up more revenue to cover fixed costs and contribute to profit.
Raise prices
Raising prices can help increase contribution margin, too, provided that customers continue to purchase products at heightened prices.
Selling products at higher prices adds revenue that can then be used to cover fixed costs. However, it must be carefully balanced with market conditions and consumer perception of value.
For example, if competitors offer similar products at lower prices, a price hike could reduce sales volume. Therefore, it is crucial to find a pricing strategy that justifies the increase in consumers’ eyes.
Assess product lines
Assessing different product lines can help ascertain which products may have a higher profit margin versus those with a lower margin.
For example, focus on promoting products with a higher profit margin or developing new products with a higher markup. This can help to significantly increase the contribution margin. Offering these products as a premium or bundling them with lower-margin products can similarly help to maximize profitability.
In addition, selling more lower-margin products can increase the overall contribution margin. For example, selling a large volume of low-margin products may allow a business to reduce its overall fixed costs.
However, if a product line isn’t contributing to a healthy contribution margin at all, businesses may be better off eliminating it entirely so that they have more resources and money to invest in other areas.
Bottom line
Contribution margin not only helps to attain profitability, but also to find areas affecting cash flow, such as dead stocks, inefficient work processes, and overpriced suppliers, etc.
Contribution margin helps sellers and businesses evaluate their financial health and look for ways to make improved business decisions. For this reason, make sure to evaluate your contribution margin today.
