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Every product your business sells generates revenue. That revenue pays your costs of doing business, and once those costs have been recouped, any additional revenue becomes profit. Companies use a simple calculation called the contribution margin to determine how much money their products contribute toward paying their costs and generating profits. This margin can be calculated for a total production run as well as for individual units.
Two Kinds of Costs
Production costs fall into two broad categories: fixed costs and variable costs. Fixed costs are those that stay the same regardless of how much you produce -- or whether you produce at all. If you rent your manufacturing space, for example, your rent is probably a fixed cost: You pay the same amount each month whether you have your production lines running or sitting idle. Variable costs are those that rise and fall with production. The cost of materials is a typical variable cost for a manufacturer: The more you produce, the more you'll need to spend on materials.
Contribution Margin Basics
In simplest terms, the contribution margin of an item is its price -- the revenue it generates -- minus its variable costs. Say you make T-shirts and sell them for $10. Each shirt has $8 in variable costs associated with it, such as fabric and direct labor. The contribution margin of each shirt you sell, then, is $2. That's $2 you can use to pay your fixed costs. Once you sell enough shirts to cover fixed costs, each additional shirt you sell contributes $2 in profit. Dividing the margin by the price expresses the contribution as a percentage, sometimes called the contribution margin ratio. In this case, the $2 margin divided by the $10 price gives you a ratio of 20 percent.
Calculating the Total Margin
Contribution margin is easier to calculate for a total production run than for an individual item. In fact, to accurately determine the margin on a per-unit basis, it's best to work backward from the margin for the full run. To calculate the total contribution margin, start with the sales revenue generated by a product; this is the total amount you received from selling the product. From that amount, subtract the total variable costs in the production run. The result is the margin. For example, say you produced 105,000 shirts. Some shirts went unsold, while you sold others at a discount from the $10 list price, so your total revenue was $920,000. Your total variable costs for the production run came out to $750,000. Your shirts have a contribution margin of $170,000. The ratio is 18.48 percent.
To calculate your per-unit contribution margin, divide the total margin by the number of units produced. In the example, dividing the margin of $170,000 by the 105,000 shirts you produced gives you a unit margin of $1.62 per shirt. Assuming that the revenue generated by this production run is more or less typical, you can use this figure to determine how many shirts you have to make to break even. Say your company's fixed costs are $500,000 a year. With a $1.62 per shirt contribution margin, you would have to produce 308,642 shirts to cover all your fixed costs and start turning a profit.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.