Contribution Margin

Contribution Margin (CM) is an accounting calculation that shows the profitability of a single sale. The formula is selling price per unit minus variable costs per unit.

What is Contribution Margin?


Contribution margin (CM), also called unit contribution margin (UCM), is an important accounting metric that highlights the profitability of a single sale. When running a business, it can be difficult to look at a complete financial statement and understand individual trends. CM can cut through the noise and provide a look into whether your revenue is generating enough profit to cover your overhead.
All things being equal, a company will want a higher contribution margin as that will leave more money to cover fixed costs and, hopefully, generate a profit.

Contribution Margin = Selling Price Per Unit - Variable Cost Per Unit

Contribution margin is what is left after deducting variable costs from revenue.
Contribution margin has two components, selling price per unit and variable costs per unit. Selling price per unit is the net sales figure for the item that you sell, whereas variable cost per unit is the incremental cost that you incur to produce or source that item.
If you sell multiple products or SKUs, you will want to track a CM for each item. It is also common to track an average CM that will show, on average, profitability of your sales. You can also look at the contribution margin ratio, which is contribution margin per unit divided by sales price per unit.

Contribution Margin Ratio = Contribution Margin Per Unit / Sales Price Per Unit


In this post, we will go into more detail on the contribution margin formula, examples, explanations, analysis, and more.


Contribution Margin Formula


The contribution margin formula is:


Contribution Margin = Selling Price Per Unit - Variable Cost Per Unit


As mentioned, the goal of CM is to understand if your individual sale is profitable and, if it’s profitable, how much profit is generated by selling one additional unit. The formula is simple but requires good accounting in order to get accurate numbers.

If you have the total numbers, you will need to divide them by the number of units sold in a given accounting period. For example:


CM = (Net Sales / Units Sold) - (Total Variable Costs / Units Sold)

CM = Selling Price Per Unit - Variable Cost Per Unit


You calculate Selling Price Per Unit by taking your Net Sales and dividing by the total number of units sold.It’s important to look at Net Sales, which includes refunds, discounts, returns, and other allowances. Offering coupon codes, bundle discounts, and other marketing offers will lower your average selling price (ASP) and need to be included in this calculation.
You calculate variable cost per unit, also called unit variable cost, by looking at the sum total of expenses required to build or purchase your inventory (total variable costs) divided by the total number of units sold.If you manufacture your own goods, then you must look at raw material costs, direct labor costs, utility costs, shipping costs, commissions, and more. If you purchase goods, then you must look at the price you pay the vendor at the end of the day, inclusive of all taxes, fees, and delivery expenses.

Examples of Contribution Margin


We will now show you how to calculate contribution margin with two examples.


Company A

  • Selling Price Per Unit = $67
  • Variable Cost Per Unit = $47

In this example, we are given the per unit values so we can use the short version of the formula:


  • CM = Selling Price Per Unit - Variable Cost Per Unit
  • CM = $67 - $47
  • CM = $20

For Company A, every time they sell a product, they will earn $20 of contribution margin that can be used to cover overhead. Once their overhead is covered, this value contributes to the company's profit.


Company B

  • Net Sales = $350,000
  • Variable Costs = $200,000
  • Units Sold = 1,000

We are given net sales, variable costs, and units sold. With these values, we can calculate our sales price per unit and variable costs per unit.


CM = Selling Price Per Unit - Variable Cost Per Unit

CM = (Net Sales / Units Sold) - (Variable Costs / Units Sold)

CM = ($350,000 / 1,000) - ($200,000 / 1,000)

CM = $350 - $200

CM = $150


In this example, we calculated everything together. First, we found that the sales price per unit was $350 and variable costs per unit was $200. Next, we subtracted these values to find the contribution margin, which was $150.


Fixed vs. Variable Costs


In accounting, fixed costs refer to business expenses that are constant regardless of the quantity of goods produced or services rendered. Examples of fixed costs are rent, wages, insurance, interest expense, utility expense, legal expenses, amortization, and depreciation. The sum of these expenses is called total fixed costs.
By contrast, variable costs refer to business expenses that vary based on the level of output. The sum of your variable costs is called total variable costs. As you sell more units, your variable costs will rise and as your sales drop, variable costs will fall too. Examples of variable costs are direct labor, packaging, shipping, and raw materials.

If you run a manufacturing business, it is important to note that you can allocate a portion of expenses to your variable costs if their value is directly tied to your production/sales volume. For example, if you have an employee who is paid based on the number of units that they produce, their costs are variable and tied to your production.


Low vs. High Contribution Margins


The price of your product will directly impact the strength of your contribution margins. All things equal, a business will want high contribution margins as that means they will have more revenue left over after paying their variable costs.

That being said, not all high contribution margin businesses are attractive. There is typically a tradeoff between having a labor-intensive business (low upfront costs, but high incremental cost equals a low contribution margin) and a capital-intensive business (high upfront costs, but low incremental cost equals a high contribution margin).

A skilled tradesperson is an example of a low contribution margin business, whereas a giant factory that produces rubber will have a high contribution margin.

To improve your CM, you will need to increase prices or cut variable costs. Reducing your fixed costs will help the overall profitability of your business, but not your contribution margin.


Contribution Margin Ratio


You can also look at the contribution margin ratio (CM Ratio), which is contribution margin per unit divided by sales price per unit. The following formula is used to calculate contribution margin ratio:


Contribution Margin Ratio = (Contribution Margin Per Unit / Sales Price Per Unit) x 100

The contribution margin ratio is contribution margin divided by the sales price. It's a metric expressed as a percentage.

In this example, we walk through using the contribution margin ratio formula:


Example

  • Net Sales: $100,000
  • Variable Costs: $64,000
  • Unit Sales: 500

Here is the walkthrough...


CM = Sales Price Per Unit - Variable Cost Per Unit

CM = ($100,000 / 500) - ($64,000 / 500)

CM = $2,000 - $1,280

CM = $720


Now we can use this Contribution Margin value to find the CM Ratio…


CM Ratio = (Contribution Margin Per Unit / Sales Price Per Unit) x 100

CM Ratio = ($720 / $2,000) x 100

CM Ratio = 0.36 x 100

CM Ratio = 36%


For every unit sold, the business will earn $720 of contribution margin, which is 36% of their sales price of $2,000.


Final Thoughts


CM is a key accounting metric to track. At its core, a business needs to understand its profitability when they sell an incremental unit. While many business owners and managers will think they know their contribution margin, it is important to put pen to paper.

Expenses like taxes, fees, shipping, insurance, and utilities are often not factored into variable costs. Moreover, coupon codes, discounts, refunds, and sales are often ignored when calculating the net sales number. That’s why the contribution margin that people believe they have is often higher than it is in reality. And given the importance of your product’s contribution margin, we highly recommend calculating this metric on a monthly basis.

The contribution margin formula is selling price per unit - variable cost per unit. This is an example of looking at the unit economics of a business to understand where revenue, expenses, and profits are coming from. Given the number of products and sales channels present today, it’s worth taking the time to understand your unit price and unit costs.

Investors and industry analysts will also use CM to understand the potential profitability of a business (e.g., once the total fixed costs are covered, how much will fall to the bottom line). The metric can be calculated for an entire business, department, factory, sales channel, product line, or for each individual product.

The right way to calculate contribution margin and its derivatives, like contribution margin ratio, will vary based on the business maturity and sophistication.

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