What is contribution margin and how is it calculated?

The contribution margin measures the profitability of a product. It helps companies to make strategic decisions when they have to choose between the production of several products or when they have to adjust their product range. Here we show you examples of how to calculate and work with the contribution margin.

Contribution margin: Definition

Contribution margin is a key figure that indicates what proportion of revenue remains after variable costs have been deducted. The remaining amount must at least cover the company's fixed costs so that no losses are incurred.

One can relate the contribution margin to the unit basis as well as to the turnover one makes with the sale of a certain product during a certain period of time.

With the calculation of the contribution margin, estimates can be made as to how high the success is through the sale of a product and what profits can be achieved through this.

Contribution margin vs. gross margin

While the contribution margin indicates the profitability of a product, the gross margin shows the amount of turnover remaining after all production costs have been deducted. The gross margin is also referred to as the gross profit margin.

Contribution margin: Formula

There are different formulas for calculating the contribution margin, depending on which aspect you want to look at more closely. We present all the important ones here.

Contribution margin per unit

The formula for contribution margin per unit is:

Contribution margin per unit = Revenue per unit - variable costs per unit

This formula indicates the amount left over to cover fixed costs when a unit is sold.

If you want to calculate the contribution margin for a single product over a certain period of time (e.g. one month), you add up the variable unit costs during this period and the generated turnover:

Contribution margin = Sum of revenue - sum of variable costs

Contribution margin ratio

If you put the contribution margin in relation to the turnover, you get:

Contribution margin ratio = Contribution margin / Revenue

This formula can be applied on a per unit basis as well as to the number of multiple products sold during a given period.

Contribution margin in percentage

The upper ratio can also be expressed as a percentage. To do this, simply multiply the contribution margin ratio by a factor of 100:

Contribution margin ratio = Contribution margin / Revenue x 100

Contribution margin & Break Even Point

The contribution margin is used in the calculation of the break-even point. At this point, the turnover is just high enough to cover all fixed costs. The formula for this looks like this:

Break Even Point = Fixed costs / contribution margin per unit

Example for contribution margin

To illustrate the above formulae, let's take an example: A company produces smoothies. The variable cost per smoothie is £1.30 and the selling price is £3.00. We now calculate like this:

Contribution margin per unit = £3.00 - £1.30 = £1.70

This leaves the company with £1.70 per smoothie sold, which helps to cover fixed costs.

If we put the contribution margin in relation to turnover, we get:

Contribution margin ratio = £1.70 / £3.00 x 100 = 56.67%

Of the turnover, 56.67% is available to the company to cover fixed costs.

In conjunction with the break-even analysis, we can now also calculate how many smoothies the company needs to sell to cover its fixed costs. The fixed costs total £1,000 per month for rent, running costs of the smoothie production line and salaries for the staff.

Break Even Point = £1,000 / £1.70 = 588.23

If the company sells at least 589 smoothies every month, it can fully cover its fixed costs. A profit is not yet made. Only when 590 smoothies are sold does something remain from the contribution margin, so that a profit is then made.

Contribution margin: Interpretation

With the contribution margin we measure product efficiency, that is, how big its contribution is to the success of the company. If we calculate this key figure, we get one of three cases:

• Contribution margin = 0: Here the fixed costs are just covered by the turnover. There is neither a profit nor a loss for the company.
• Contribution margin > 0: A value greater than zero indicates that an amount remains with which the fixed costs can be covered and a profit is made after the break-even point is reached.
• Contribution margin < 0: With a negative value, the fixed costs are not covered by the sale of the product. The company incurs losses and the product is not profitable.

Why is the contribution margin important for companies?

The contribution margin helps companies make strategic decisions. If the smoothie company in the example above has a choice between producing several different smoothies, it can calculate the contribution margin to find out which variant is most profitable and then produce it.

If you monitor the contribution margin of your individual products over a certain period of time, you can also see how their sales success and manufacturing costs develop. For example, if the cost of raw materials increases, this is reflected in higher variable costs, which reduces the contribution margin. Companies can then decide whether to adjust prices to compensate for this loss.

If customer demand for a product falls continuously over a period of time, this is reflected in falling sales, which in turn reduces the contribution margin. Also then, companies can more easily make a decision whether to continue manufacturing the product or to stop production because demand is no longer expected to increase.

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