What is Contribution Margin?
A business’s contribution margin – also called the gross margin – is the money left over from sales after paying all variable expenses associated with producing a product. Subtracting fixed expenses, such as rent, equipment leases, and salaries from your contribution margin yields your net income, or profit.
Calculating Contribution Margin
Your contribution margin is calculated by taking:
Product revenue generated – product variable costs/ Product revenue generated
So if a company generated $250,000 from product sales, which had associated variable costs of $100,000, the contribution margin would be:
250,000 – 100,000/250,000 = .60 or 60%
What is a Good Contribution Margin?
The closer a contribution margin percent, or ratio, is to 100%, the better. The higher the ratio, the more money is available to cover the business’s overhead expenses, or fixed costs.
However, it’s more likely that the contribution margin ratio is well below 100%, and probably below 50%.
The contribution margin ratio can be used as a measure of a company’s profitability as well as a measure of how profitable a particular product line is. Evaluating the contribution margin ratio for a certain brand or product can help determine if it makes sense for the company to continue selling it at its current price. If the contribution margin is extremely low, there is likely not enough profit available to make it worth keeping. Eliminating low contribution margin products can positively impact a company’s overall contribution margin.
Improving Contribution Margin
In order to improve a company’s contribution margin you either need to reduce variable costs, such as raw material and shipping expenses, or increase the price of your products and services.
The lower your contribution margin, the more difficult it is for your business to cover your fixed costs. Cutting those costs, such as by relocating into less expensive space or eliminating non-essential positions, is one way to improve your financial position.