Contribution margin is profit of the business, but it's a broad topic. There are ways to broadly factor it, but getting into the details can provide a much better picture of the business's overall health. Read on for a better definition, why it's important and to see how to calculate it.
Before we learn how to calculate it, let's define it first. In business, we often use the term "margin" to mean profit. So contribution margin is nothing more than a way to see if our operation is profitable. So why not just say profit instead of contribution margin? That's an excellent question. And the answer is because there are various "profits" that one can focus on. For instance, there's gross profit, operating profit, contribution margin and many other types of profits. So contribution margin is just one of the many profit measures. And each one focuses on a different area of our operations.
Now that you understand what contribution margin is, let's briefly discuss why it's important and useful. In a nutshell, costs to any business fall into two broad categories: fixed costs and variable costs. Fixed costs are those whose amounts rarely, if ever, change. So they're basically fixed, meaning steady and unchangeable. By contrast, variable costs are the exact opposite. They can, and most often do, fluctuate wildly. For example, rent is a fixed cost. Does rent on an apartment change every month? No. Does a home mortgage payment constantly change? No. But what about something like your electric or gas bill? Do you pay the same amounts every month? No, it changes. So these would be examples of variable costs. Contribution margin focuses on variable costs. And why? Because they're the ones that change and are far more unpredictable. And that makes them harder to control and predict. In other words, fixed costs are known. So you can easily plan for what they'll be next month and quarter. And that's because those amounts remain constant. But with variable costs changing all the time, it's much harder to know what they'll be. So one month or quarter, they could be very high. The next, they could be relatively low. So contribution margin is a profit measure that looks at how your company is managing those ever-changing variable costs. And because management is responsible for keeping costs under control, contribution margin is a way to gauge how well management is doing.
Ok, you now understand what contribution margin is and it's purpose. Now we're at the point where we can actually calculate it. Our starting point is total or gross sales. This is the total amount of sales we had for a particular period. Now, some businesses lump sales of all products together into one figure. Others will separate them out so they can track sales of individual products or product types. When calculating contribution margin, it's best to do it for both individual product lines and all products. Why? Because it's possible to have one product line performing better. In other words, management may have a better handle on that product's variable costs than another product. So you can still be profitable overall, yet not profitable with a particular product. Management, investors and creditors are very interested in knowing this. Now once you have your sales figures, you simply deduct your variable costs from them. With gross sales, you deduct total variable costs. And that's because you're looking at all products together as one. The result of this subtraction is your contribution margin. When you are looking at each product line's contribution margin, you basically do the same thing. The only change is you start with that product line's gross sales. And then subtract out that product line's variable costs. The end result will be that product line's contribution margin.
When you are calculating your contribution margin, you want to list each variable cost separately. In other words, don't do this: sales equals $500,000; variable costs equals $50,000 and contribution margin is $450,000. What's the problem in doing things this way? Well, your problem is that you can't see which variable costs are the most or out of control. And that's because they're all lumped together. However, what if I did it this way: sales equal $500,000; variable costs including materials is $15,000, labor is $20,000 and utilities is $15,000 for a total of $50,000; and the contribution margin equals $450,000. By breaking down your variable costs into their components, you can actively monitor each one to see how well they're being managed over time. For example, we've got a handle on our material costs but not our labor.
Make sure you properly categorize your costs as fixed or variable. First, it'll throw your calculations off. Second, the person looking at the results can make a bad decision because the numbers aren't correct.