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Contribution Margin

Learn the Steps to Calculate the Contribution Margin and CM Ratio

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Contribution Margin

Key Learning Objectives
  • What does the contribution margin measure?
  • What is the formula used to calculate the contribution margin?
  • How is the contribution margin related to the break-even concept?
  • Why might the contribution margin be preferred over the gross margin metric?

Contribution Margin Concept

While there are various profitability metrics – ranging from the gross margin down to the net profit margin – the contribution margin metric stands out for the analysis of a specific product/service.

The contribution margin is the profits generated after variable costs have been deducted – i.e. how much revenue exceeds the associated variable costs.

Instead of looking at the profitability of a company on an overall basis with all products grouped together, the contribution margin enables margin analysis on an individual product line basis.

In particular, the use-case of the contribution margin metrics tends to be most applicable for setting prices appropriately.

If the contribution margin is too low, the current price point may need to be reconsidered.

In such cases, the price of the product would either be:

  • Increased: The pricing of the product line could be raised to contribute towards more profitability, as the current profit margins are unsustainable.
  • (or) Discontinued: The product offering could be discontinued if there is insufficient customer demand after a potential price increase.

Additionally, the assessment of the contribution margin can help determine the optimal pricing by assessing the impact each change would have on revenue and profitability levels.

Given how the contribution margin examines the product-level breakdown of each dollar that comes in and how it contributes to generating profit, the break-even point cannot be calculated without determining the contribution margin.

For companies seeking to obtain a sustainable long-term competitive advantage, it’s important to focus on identifying the products with the highest contribution margins in order to maximize potential profits.

Contribution Margin Formula

The calculation of the contribution margin is relatively straightforward, as the formula consists of revenue minus variable costs.

Contribution Margin Formula

Just as a quick review, a company’s variable costs are directly associated with revenue and fluctuate based on production volume, whereas fixed costs remain unchanged regardless of production volume.

  • Variable Costs: e.g. Purchase of Inventory/Materials, Direct Labor, Shipping Costs
  • Fixed Costs: e.g. Utilities, Rent, Insurance, Equipment

The distinction pertains to the concept of scalability, as companies with higher variable costs tend to bring in fewer profits since the direct costs increase (and can offset) the growth in revenue.

All else being equal, the greater the contribution margin of each product, the more profitable the company is going to be, with more cash available to meet other expenses.

Furthermore, to perform a more detailed analysis on either a quarterly or year-over-year (YoY) basis – or comparisons to comparable companies in the same industry – the contribution margin can be divided by revenue to get to the contribution margin ratio.

Contribution Margin Ratio Formula

To go through a simple example, let’s say there’s an e-commerce company selling t-shirts for $25.00 with variable costs of $10.00 per unit.

The formula used to calculate the contribution margin would be as follows:

  • Contribution Margin = Revenue – Variable Costs
  • Contribution Margin = $25.00 – $10.00 = $15.00

Next, the contribution margin ratio can be calculated using the following formula:

  • Contribution Margin Ratio = (Revenue – Variable Costs) ÷ Revenue
  • Contribution Margin Ratio = $15.00 ÷ $25.00 = 60%

The 60% contribution margin ratio means that the contribution margin for each dollar of revenue generated is $0.60.

Contribution Margin vs Gross Margin

One common area of misunderstanding is related to the difference between the contribution margin and the gross profit margin.

The gross margin metric – which is calculated as gross profit divided by revenue – measures the amount of revenue remaining once all direct costs (i.e. cost of goods sold, or COGS) have been subtracted.

When it comes to the contribution margin, the intent behind the calculation is similar, but can be analyzed more in-depth on a per-item/per-product profitability level.

On the other hand, the gross margin represents the total profit metric inclusive of all products/services offered by the company.

Contribution Margin Excel Template

Now that we’ve discussed the use-case of the contribution margin as well as the contribution margin ratio, we can move on to some example calculations.

For access to the model template, fill out the form below:

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Contribution Margin Model Assumptions

As the first step, we’ll begin by listing out the model assumptions for our simple exercise.

As of Year 0, the first year of our projections, our hypothetical company has the following financials.

Model Assumptions

Income Statement Data (Year 0)

  • Total Product Revenue: $1m
  • Number of Products Sold: 10k
  • Total Variable Costs: $400k

Using the provided data above, we can calculate the price per unit by dividing the total product revenue by the number of products sold.

  • Price Per Unit = $1m ÷ 10k = $100.00

Similarly, we can then calculate the variable cost per unit by dividing the total variable costs by the number of products sold.

  • Variable Cost Per Unit = $400k ÷ 10k = $40.00

For the rest of the forecast period – i.e. Year 1 and onward – we’ll just assume that each line item will grow by the following:

  • Total Product Revenue: Increase by +$200k / Year
  • Number of Products Sold: Increase by +2k / Year
  • Total Variable Costs: Increase by +$50k / Year

If we fill out the “Price Per Unit” and “Variable Cost Per Unit” for each projected year, from Year 0 to Year 5, the figures change from:

  • Price Per Unit: No Change ($100.00)
  • Variable Cost Per Unit: $40.00 → $32.50

For this section of the exercise, the key takeaway is that the contribution margin requires finding the revenue from the sale of a specific product line, along with the specific variable costs.

In effect, the process can be more difficult in comparison to a quick calculation of gross profit and the gross margin using the income statement, yet is worthwhile in terms of deriving product-level insights.

Contribution Margin Example Calculation

We’ll next calculate the contribution margin and ratio in each of the projected periods in the final step.

To calculate the contribution margin, we simply deduct the variable cost per unit from the price per unit. For instance, in Year 0, we use the following formula.

  • Contribution Margin = $100.00 – $40.00 = $60.00

Next, the contribution margin ratio can be calculated by dividing the amount from the prior step by the price per unit, as shown in the screenshot below.

CM Ratio Formula

In Year 0, if we divide the contribution margin by the price per unit, we get the following CM margin %:

  • Contribution Margin Ratio = $60.00 ÷ $100.00 = 60.0%

Here, we are calculating the contribution margin on a per-unit basis, but the same values would be obtained if we had used the total figures instead.

From Year 0 to Year 5, the following changes occur:

  • Contribution Margin: $60.00 → $67.50
  • Contribution Margin Ratio: 60.0% → 67.5%

Note that the overarching objective of calculating the contribution margin is to figure out how to improve operating efficiency by lowering each product’s variable costs, which collectively contributes to higher profitability.

The profitability of our company likely benefited from the increased contribution margin per product, as the contribution per dollar increased from $0.60 to $0.68.

Contribution Margin Output

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