Knowing your contribution margins can help you determine whether your company gains or loses money from making and selling one or more of your products. If you notice that a product has a low contribution margin, this signals that your company may not even make enough to pay for the costs of making the product.
A high contribution margin, on the other hand, is a good sign since it indicates your company should at least be able to make enough to pay for the related costs and hopefully achieve profitability. Increasing your contribution margins can involve taking measures to cut relevant costs and boost money made from sales.
Basics of the Contribution Margin
The contribution margin refers to how much money your company gets from your sales after you deduct directly related costs for production. It doesn't consider any fixed costs such as leases and rents that don't directly relate to making your products.
You might look at the contribution margin by product report to see the profitability of a certain product, or you might determine the contribution margin for your company's total sales to evaluate overall performance. In either case, the contribution margin will show you the money you'll have for each product sale to pay for your fixed costs as well as what will be left over for profit.
Contribution Margin Formula
The contribution margin formula to use to get a dollar amount is net sales revenue - variable costs. You can also express the contribution margin as a percentage with the formula (net sales revenue - variable costs) / net sales revenue.
To get your net sales revenue, you take your total sales revenue and subtract any discounts, returns and allowances. To get your variable costs, you'll add expenses such as materials, production labor, utilities expenses and other costs directly related to making the product.
Importance of Contribution Margin
Knowing the contribution margin comes in handy when you perform a break-even analysis since it can give you insight on how to manage costs and anticipate the product sales needed to cover those costs and hopefully earn a profit. It can also help you know which product lines have the highest costs and look for ways to improve efficiency so that you generate more profit for each sale. It can also help you with determining optimal pricing strategies.
Raising the Contribution Margin by Increasing Sales
Since the contribution margin formula takes your net sales into account, you can potentially raise your contribution margin if you can make more money for your products. You can do this a few different ways.
- Raise the per-item cost: First, you can increase the selling price for each product. This strategy requires being careful to not raise the price so high that it makes customers look elsewhere. As long as your variable costs stay the same and you can maintain at least your usual sales volume, this strategy should boost the contribution margin due to higher net sales.
- Boost your company's total sales volume: If you can make some of your variable costs decrease with volume, you may boost your contribution margin if you can gain additional sales revenue from current and new customers. Reaching out to current customers to encourage follow-up sales as well as suggesting additional products to boost the invoice amount can help accomplish higher revenues.
- Sell a new product or service: When you want to boost your company's overall contribution margin rather than focus on a specific product, you can consider adding a new product or service to your company's offerings that would have low variable costs and high revenue potential. This approach has some more risk since product development comes at a cost, and you don't have a guarantee that customers will buy enough of the new product or service to make a significant difference to your contribution margin. You also have to stay mindful of variable costs.
- Re-evaluate any customer discount programs: Any discounts you offer to customers will lower your net sales and make your contribution margin go decrease. While offering discounts can help boost sales, it can also make you lose money in the long term. So, consider re-evaluating discount programs to potentially offer them for only a period of time and then raise the price slightly for future orders. This can be challenging if you try to take away discounts from current customers, so you might try it on new customers instead with a discount on their first few orders.
Raising the Contribution Margin by Saving Money
Your variable costs have a large impact on your contribution margin along with deductions from your total sales such as returns, discounts and allowances. Thus, trying some of the following methods to cut costs or at least reduce their impact can help you boost your contribution margin.
- Find cheaper materials: If you've used the same supplier for a long time, chances are that the cost of raw materials may have gone up. It's worth researching other suppliers who may provide the same materials for less money and help you reduce your variable costs per product. However, you'll want to also pay attention to quality since you can lose more money instead if you need to scrap materials and redo work.
- Lower your product labor costs: The labor put toward making each product will be a deduction as part of variable costs, so you can boost your contribution margin if you can find less-expensive employees or improve the efficiency of the workflow. For example, you might consider using a commissions system based on performance rather than paying employees a flat rate or salary, or you may consider outsourcing. You might also update any outdated equipment to take advantage of tools that allow your employees to create products more quickly.
- Decrease other variable expenses: You also have other variable costs such as utilities, packaging and production supplies to consider. Improving operational efficiency and using greener machinery can lower utilities costs and impact your contribution margin positively. You can also seek cheaper ways of packing your products and look for discounts on production supplies to minimize such expenses.
- Improve product quality: The net sales portion of the contribution margin formula subtracts costs from sales allowances and returns. This means that you can reduce such costs if you ensure that your products and services meet acceptable quality standards and keep your customers satisfied. Although people may still return products simply because they changed their mind, you can at least reduce the negative impact of defective products and waste from your contribution margin.
Taking a Combination Approach
To increase your contribution margins most effectively, you'll likely find that you need to both cut your costs and bring in more sales. For example, you might look for ways to increase product awareness to increase your sales volume as well as research cheaper suppliers that offer competitive rates for large purchase amounts. You might also seek ways to improve products and add value for your current customers since this can also save you money in terms of fewer returns and higher customer satisfaction.
For the best results, regularly evaluate your contribution margin as you experiment with different strategies so you can find what works well for your company.