Contribution margin - What is a contribution margin?
A contribution margin is the marginal profit per unit sale, and is the sum of a company’s turnover less their direct costs
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The contribution margin is a measure of how much money a company has remaining, after direct sales costs, in order to pay their fixed costs.
Why the contribution margin matters
For a business, determining the contribution margin for a particular product could be useful because it provides an indication of what percentage that product contributes to overall sales.
Products with low contribution margins should then be examined to determine whether the production costs for that item can be reduced, or whether the final price for the item can be increased in order to improve the contribution margin.
If it is estimated that neither approach will yield positive results, the product can be dropped from the line completely.
Why a high contribution margin is better
A good contribution margin is one that can cover the costs of creating the product and, ideally, generate a profit. If the contribution margin is too low or is negative, this will mean loss for the company.
Example: calculating a contribution margin
A company sells Product Z for £150.00. They have direct costs in terms of purchasing, packaging and freight. The purchase price is £60.00, the packaging is £5.00 and the freight is £10.00
The arithmetic of gross margin will therefore be:
Sales Price = 150 - Purchase price: 60 - Packaging: 5 - Freight: 10 Margin = 75
The company now has £75.00 leftover to cover their fixed costs - such as rent, payroll, etc. If the margin is not high enough to cover the fixed costs, there will be a deficit in the company. Inversely, there will be a surplus (profit) if the contribution margin exceeds the company’s fixed costs.
Using the contribution margin in comparison
It is not recommended to compare contribution margins across different industries, because the contribution margin can be vastly different depending on the type of business involved.
Some companies may have a high contribution margin, but also many fixed costs - whereas other companies may have a low contribution margin and fewer fixed costs. The company's contribution margin will always appear in the profit and loss account.
Contribution margin and Debitoor
Using Debitoor accounting software allows you to easily track your sales and expenses. Match your transactions with automatic bank reconciliation and view your accounting reports to gain a solid understanding of how your products perform.