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Contribution Margin Explained

Business owners face many financial challenges, so understanding contribution margin is crucial to success. Contribution margin is an essential financial metric for any business striving to increase growth and revenue.

It is a tool used to evaluate the earnings generated by a company's products or services after subtracting variable expenses. This blog post aims to explain what the contribution margin is, why it is essential, how to calculate it, and finally, offer useful tips for improving it.

Contribution Margin Defined

Firstly, let's define contribution margin. It is the revenue left after paying for variable expenses, such as the cost of producing a product, and excluding fixed costs like rent.

In simpler terms, contribution margin is a way to measure how much money a product or service generates to cover fixed costs and make a profit. The formula for calculating contribution margin is straightforward:

Contribution Margin = Sales Revenue - Variable Costs

Secondly, contribution margin can define a company's profitability. Having a high contribution margin means a company can generate more profit, cover fixed costs, reduce risks, and outcompete other businesses in the industry.

Managers use contribution margins to compare prices, assess the performance of different products, decide whether to drop a product line, and make pricing decisions.

Making Decisions with Contribution Margin

Understanding contribution margin can allow companies to make informed decisions. By calculating their contribution margin, businesses can determine if a product generates enough revenue to cover the variable costs.

If a product's contribution margin is less than the fixed costs, the business should consider discontinuing the product or finding ways to reduce variable costs.

Improving Contribution Margin

There are various ways businesses can improve their contribution margin. One way is to increase prices, change suppliers or find lower-cost raw materials, and reduce production costs. Additionally, companies can produce goods that offer higher contribution margins, or invest in research or development to create more innovative products or services that generate higher profits.

Companies use the contribution margin to determine their break-even point. Break-even is the point where a company covers its costs but doesn't make a profit. Therefore, if the contribution margin for all products is high, a company can determine how to reduce costs and charge a lower price or vice-versa.

Using Software Systems to Analyze Contribution Margin

Calculating contribution margin as part of a company's financial analysis may seem straightforward, but manually tracking sales revenue and the various variable costs needed to compute the metric can be time-consuming and prone to errors. However, by utilizing enterprise resource planning (ERP) software, like NetSuite, businesses can alleviate this burden. NetSuite's financial management and cloud accounting solutions gather all the necessary financial data to accurately calculate contribution margin, ensuring that no costs are missed and results are not skewed.

Furthermore, the system provides a comprehensive classification of every transaction and expense, right down to the SKU or item level. This enables businesses to gain a deep understanding of the costs associated with each specific product. Moreover, NetSuite's role-based dashboards empower stakeholders to identify emerging trends, flag potential issues, and make crucial decisions regarding product offerings, pricing strategies, and expense reduction measures to enhance profitability.

Tracking contribution margin is a core part of a financial analysis that aims to measure the profitability of a specific product, service, or entire line of either. Contribution margin helps business leaders make informed decisions about factors like product and service pricing; whether it should add, scale back, or eliminate specific offerings; and ways to contain costs. The higher the contribution margin for a given item, the more revenue that will remain for a business to use to pay its fixed expenses, surpass its break-even point, and ultimately, realize a profit.

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