Gross profit is an important key performance indicator (KPI) to track, but so is the contribution margin. Many business owners, unfortunately, overlook contribution margin or do not fully understand what it represents. To truly understand your business's financials, learn what contribution margin is, how you calculate it, and what the number means for your business's ability to grow and expand.
What Is Contribution Margin?
The contribution margin represents the amount of revenue remaining in a business after all variable costs have been subtracted. The contribution margin is the remaining revenue that can be put toward covering fixed costs and reinvesting in the business. Essentially, a contribution margin (calculated for a business as a whole or for specific products and services) represents the business's break-even point.
The contribution margin can also be expressed as a percentage, called the contribution margin ratio, which expresses the figure as a percentage of total revenue. It is simpler to judge financial performance, at a glance, using the contribution margin ratio than it is using the contribution margin figure.
Don't Confuse Contribution Margin with Gross Profit Margin — Know the Difference
Gross profit margin represents revenue left over after subtracting the cost of goods sold from total sales. Cost of goods sold includes all expenses — variable and fixed — that contributed directly to the cost of producing a product or providing a service. The small difference between contribution margin and gross profit margin are the fixed costs included in a company's cost of goods sold because contribution margin only considers the revenue after variable costs.
Calculating Contribution Margin and the Contribution Margin Ratio
Contribution Margin = Sales Revenue - Variable Costs
Contribution Margin Ratio = ((Sales Revenue - Variable Costs) / Sales Revenue) x 100
Separating Fixed Costs from Variable Costs
When calculating contribution margin, you must determine which costs are considered variable and which are considered fixed. Variable costs include any expenses that increase and decrease in correlation with the number of products produced or services rendered. For example, in a business manufacturing widgets, the cost of direct materials and labor increases with the number of widgets produced. If, in the same business, sales associates earn a commission on widget sales, then this commission should also be considered a variable cost.
Variable costs, obviously, do not include fixed costs like rent, insurance, equipment rentals (unless paid by the hour and more or less time is spent on a particular job) and employee salaries that do not increase or decrease with respect to production and sales.
Why Your Growing and Expanding Business Can't Survive without Knowing Contribution Margins
Looking at contribution margin — for your business as a whole or for individual jobs, products, customers, and services — should be invaluable to your wealth of financial knowledge because you can't calculate your break-even point without it.
The break-even point in a business represents the amount of revenue or units of sales needed to cover all the company's costs (fixed and variable) before it begins generating a profit.
Using Contribution Margin to Calculate Your Break-Even Point
Whether analyzing a business's overall break-even point or unit-based break-even point, the contribution margin is an essential component of the break-even point equation:
- Break-Even Point = Total Fixed Costs / (Total Sales Revenue - Variable Costs)
- Break-Even Point in Units = Total Fixed Costs / (Contribution Margin per Unit)
Applying Break-Even Analysis to a Data-Driven Business Strategy
Knowing exactly how much revenue you must generate to cover costs and break-even in your business will help you set goals for your company's future growth and expansion. Using growth projects and historic data of previous sales projections compared to actual sales numbers, you can set sales goals within your company to reach predetermined profit projections, plan the expansion of your company, and make projections for reinvestment that will attract investors.
