What Is Contribution Margin and How Is It Calculated?
People who are new to business and accounting may have heard about contribution margin but may not know about its importance.
It is helpful in making decisions about sales price, sales volume, variable costs, and fixed costs for specific products or services within a company.
Making changes to the contribution margin can ultimately lead to how a business makes money.
This is the goal, no matter what type of business you are running, and understanding the impact contribution margin can make is vital.
Importance of Contribution Margin
Calculating your contribution margin directly reflects a company’s profitability.
If you have ever watched the popular television show “Shark Tank,” one of the first questions the sharks ask contestants is “how much money did you profit last year from this product?”
Why would they want to know that? Well, if a contestant is spending more money making a product that they are actually making off it, this would not be a good investment for the sharks
How to Calculate It
Contribution Margin = Sales – Variable Costs
For example, if you sell a product for $10, with a variable cost of $6, the contribution margin is $4. Your take-home profit for this sale would be $4.
Contribution margin can be calculated in two different ways:
- Total – This is most frequently used for companies to see how much variable expenses and production are impacting their revenue.
- Per unit – This measurement shows how much a company’s profits will increase with additional production
These are costs a business possesses that are not tied to the production or sale of a product.
These costs will continue to occur even when a company is not producing anything. Some examples of these include rent, insurance, electricity bills, and other basic brick-and-mortar costs.
To maintain profitability, these costs should be covered by the contribution margin.
If the contribution margin does not add up to more than the fixed expenses held by a company, then the company will not make a profit and changes must be made.
Selling Price and Production Volume
Calculating the contribution margin will help a company know whether they need to change the selling price of their products or increase their overall sales volume.
A company can also try to reduce their contribution margin by attempting to lower any fixed costs, increasing the selling price of the product, or increasing the number of units they are selling.
When a business has a higher contribution margin, it typically means that their sales volume is higher and that there are a lot of people buying their products.
Companies with lower contribution margins usually must rely on old-fashioned selling techniques, such as customer referrals, word of mouth, and newspaper advertisements.
In today’s society, the contribution margin is used and assessed largely through online businesses and e-commerce.
Today, many businesses benefit from doing business primarily online, especially with the influx of social media-driven businesses that are thriving through social advertising.
Businesses that are started online have an edge over brick-and-mortar stores in that they can be run virtually from anywhere in the world, as long as you have a laptop and internet connection.
One potential setback to this type of business, however, is that it can be tough to find your niche. Everywhere you look there is a new, up-and-coming business that could be better than yours if you do not act fast enough.
It is important during this period to create a monetization plan that will ensure you will continue to make money.
Developing a Monetization Plan
One of the most important parts of starting your online business or any business is to develop a monetization plan.
Plan out which products or services you would like to offer initially and build from there based on the initial response and what is needed.
For instance, you might decide to start an online coaching business where you offer basic training plans.
From there, you might take a nutrition course and realize you are now qualified to offer nutrition guidance in addition to your basic training plans, so you can begin to offer that product.
Then, you may decide to specialize in specific training focuses, such as building upper body strength, lower body strength, abdominal muscles, etcetera.
The key to monetization is avoiding the pitfall of remaining stagnant and growing with your audience.
Customers will often voice different requests they would like to see from you in the future, so make sure you listen to these requests and implement them if at all possible.
Some businesses offer specific plans that are customizable based on a customer or client’s need, which leaves room for offering a standard price point but making changes according to what the customer is specifically looking for in a service.
What is most essential is knowing when it is time to refine business plans.
Refining Business Plans
Great business owners understand that product and service pricing often take time to find what you are comfortable with the offering.
Try different types of offers for your products and services, different bundles, and sales.
Once you find something that works, stick to it for a measurable period of time, such as 30 days and refine it from there. If you find that your contribution margin is suffering, change things up and improve what is not working.
Finding Your Optimal Production Level
When you are figuring out how much of a product or service to sell, contribution margin can be beneficial to find what works.
For instance, a company that is selling t-shirts for a $10 per unit contribution margin but has $10,000 in fixed expenses, they would need to sell at least 1,000 t-shirts to hit a breakeven point.
If they want to make a profit of $50,000, they would need to sell 6,000 t-shirts.
Evaluating this contribution margin will help the company in this example make the appropriate changes to reach their goals and ultimate profit levels.
If you find yourself in a position where you need to increase profits to increase your contribution margin, there are several steps you can take:
1. Switch Up Operating Procedures
You will want to find a way to keep the same customers coming back to you again and again. Many places do this by creating a service plan or bundle, where customers can keep returning for, say, 10 personal training sessions at a fixed rate.
2. Trim Expenses
Take a look at how you are operating your business overall. Are there ways you can automate procedures to save money? Can you hire part-time versus full-time employees to complete tasks? These small changes may seem minor but can quickly add up over time.
3. Maximize Cash Flow
One of the most efficient ways to create a steady cash flow is to have ongoing payment plans through existing clients. This creates an ongoing relationship with your client and ensures that you have a consistent revenue stream coming in the door.
For instance, instead of offering a one-time service, create a weekly service contract where you charge an upfront rate.
So, instead of offering a service with a one-time fee of $100, try offering a 3-month plan for $250 to encourage customers to continue working with you longer than just a one-time service.
It is always important to rely on word-of-mouth customers as well because customers who enjoy your service or product offerings will almost always refer you to their friends if it comes up in conversation.
Keep this in mind when it comes to marketing your business and your offerings.
Making that good impression is more than just impressing your customer – it is about impressing their friends who they speak about you too and encouraging them to buy from you as well.
Effective marketing is what gets your name and foot in the door. Ensure your business has an online presence through Facebook, Twitter, Yelp, and YouTube and consistently check in to these various mediums.
It is also important to not only have these platforms but to keep them updated and check them frequently to make sure your customers know someone is there.
Respond to any reviews in a timely manner and be on the lookout for any incoming questions regarding your products.
This will often be the first impression a customer has of you, so make sure you make a good one because you will not always get a second chance.
Utilize Your Resources
Calculating your contribution margin is just one tool you can utilize to ensure you are adjusting your expenses appropriately and making the most revenue as possible.
There are numerous methods of keeping accounting within your business and these typically involve a lot of trial and error before the most cost-efficient method is found.
Even the most successful businesses did not always have the perfect sales plan and often required multiple tweaks and changes to their plans before they could increase revenue.
With today’s changing market and focus on online businesses, what matters most is that you create your vision statement early on, focus on the value you can bring to your customers, and how you can continue to grow and expand your business in the future.
Featured Image: CC0 Public Domain via Pixabay