Contribution margin is the difference between sales and variable expenses. Variable expenses include the direct labor and raw materials costs incurred for the manufacture or acquisition of products. These expenses also include overhead expenses, such as sales commissions, that depend on the sales volume and price. The contribution margin calculation excludes fixed overhead costs, such as rent and administrative salaries. You may increase contribution margins by increasing sales, lowering variable expenses or a combination.
Raise prices to increase sales in dollars. If your products have features that distinguish them from the competition, you may be able to set higher price points and still maintain sales volume. These unique features include better design, superior performance and personalized customer service. This differentiation approach increases contribution margins per unit but may lead to a drop in volumes as cost-conscious customers go elsewhere.
Offer discounts and guarantee the lowest prices to attract cost-conscious customers. Your per unit contribution margins may be low, but you may make up for it through higher sales volumes. However, the danger is that your competitors may match your prices and you might end up with barely enough margins to cover your fixed costs. An alternative approach that retailers often take is to advertise a few "leader" items at discounted prices to bring customers into the store, hoping they would then buy your high-margin products.
Identify new market segments for your products. Stephen F. Austin State University professors Dillard Tinsley and Phil E. Stetz introduced the concept of price partitioning in a fall 2004 University of Central Arkansas conference paper titled "Contribution Margin Pricing for Small Businesses." They cite the example of a restaurant pricing its menu according to the time of day to cater to different customer spending habits. Some businesses offer price discounts to customers who place large orders or who order months ahead of time. Promotional strategies aimed at underserved customer segments may also drive sales growth.
Reduce variable labor and raw materials costs. Retailers may be able to negotiate volume discounts with suppliers for large orders. In the aftermath of the 2008 recession, many manufacturing companies negotiated lower wages with labor organizations in exchange for maintaining employment levels. Reducing variable costs may not be possible if the economy is strong and your plants are running at full capacity. However, if you have excess capacity, you may be able to increase production while maintaining variable costs, which may increase contribution margins.
The breakeven point in units is the ratio of total fixed costs to unit contribution margins. For example, if the fixed costs are $1,000 and the contribution margin is $2 per unit, you must sell at least 200 units ($1,000 divided by 2) to break even.
- Pacific Lutheran University, Management Accounting Web; Contribution Margin; Gerald M. Myers; August 2005
- Pacific Lutheran University, Management Accounting Web; Income Statement; Gerald M. Myers; August 2005
- Capstone Manager Guide: How Can We Improve Our Contribution Margin?
- University of Central Arkansas, Small Business Advancement National Center; Association for Small Business and Entrepreneurship Fall 2004 Conference; Contribution Margin Pricing for Small Businesses; Dillard Tinsley, et al.