Contribution Margin: The Number Most Owners Do Not Look At

What contribution margin means

Contribution margin is what remains from a sale after you subtract the variable costs of making and delivering it. Variable costs are those that exist only because you made the sale: materials, packing, freight, payment fees, sales commission, and direct labour that is paid per piece or per job.

What is left contributes to the fixed costs, such as rent and core salaries, and then to profit. Expressed as a percentage of the sale price, it is the contribution margin ratio, which lets you compare products with different prices.

A simple calculation

For example, suppose a workshop sells two products. These figures are hypothetical. Product A sells for 1,000, with variable costs of 700. Product B sells for 600, with variable costs of 300. A contributes 300, or 30 percent. B contributes 300 as well, but the ratio is 50 percent.

Both bring the same amount per unit, but B uses less money and probably less stock for the same contribution. If B also takes less time to make, it deserves more of your attention than its lower price suggests. Revenue alone would have ranked A higher.

Where to use it

Look at contribution by product, by customer, by sales channel and by salesperson. You may find that your largest customer, after discounts, freight and special packing, contributes less than a smaller account. That does not mean abandoning them, but it tells you what to negotiate.

The same view helps in pricing. Before approving a discount, ask how much extra volume is needed to make up the lost contribution. A discount that looks small on the price can look large against the margin.

• Ranking products by contribution per unit and per hour of capacity
• Checking whether a discount can be earned back by volume
• Judging customers after the costs of serving them
• Deciding what to promote, bundle or drop

Be careful with the classification

The hardest part is deciding what is variable. Some costs are mixed, such as electricity in a workshop, which has a fixed element and a usage element. Estimate the variable portion sensibly and be consistent from month to month.

Do not allocate fixed costs to products and then call the result contribution. Allocation has a use, but it hides the fact that those costs continue regardless of one product's volume. Keep contribution clean, then deal with the fixed costs separately.

Make it a regular report

Once your costs are tagged, the report is simple. Prepare a monthly sheet showing sales, variable costs and contribution for each product line or customer group, with the ratio. Add last month and the average, so that changes are visible.

Review it with the sales and operations leads. When a ratio falls, ask whether input costs rose, discounts crept in, or the mix shifted. Each answer points to a different action.