How to Calculate Contribution Margin
Also referred to as “dollar contribution per unit,” contribution margin is the money you have left over after paying the variable costs to produce a product. It’s usually calculated on a per-unit basis, but you can also calculate contribution margin on a percentage basis.
In practice, contribution margin is a useful metric that’s critical for break-even analysis. It shows businesses the profitability of each product in their catalog, helping them optimize costs, expenses, and SKUs.
What is the contribution margin?
Contribution margin is the remaining revenue you have after covering the variable expenses it takes to make a product. Keep in mind that contribution margin only looks at variable costs: it’s a metric that tells businesses how much money they have left to cover fixed costs.
Contribution margin shows how much profit each product generates after you deduct the costs of making that product. If you calculate the contribution margin for all products in a business’s catalog, you can see which products contribute the most to a business’s profits.
How to use contribution margin
Although it doesn’t account for your fixed expenses, contribution margin is an essential metric that helps you understand a business’s profitability.
You can use contribution margin to determine:
- How to price your products to maximize profits.
- How much profit you can expect if you sell a certain number of units.
- Sales commission or affiliate rates.
- Which products are worth producing and which should be discontinued.
- If a business is too reliant on a hero SKU.
As an investor, contribution margins tell you the profitability of each product a company makes. If a business generates the majority of its profits from just one product, that can be a liability because the business isn’t diversifying its revenue.
The contribution margin formula
Contribution margin is easy to calculate, but you need the right information to calculate it correctly. The formula is:
Contribution margin = selling price per unit - variable cost per unit
In other words, the contribution margin formula subtracts the difference between how much you charge a customer for a product and how much you spend making that product.
However, keep in mind that the contribution margin isn’t looking at all of your costs. It’s only concerned with variable costs, not fixed costs. That’s because this formula tells businesses how much money they have available to cover fixed expenses after making their products.
To understand a product’s contribution margin, you need to know the difference between fixed and variable costs.
Fixed costs are one-time purchases that don’t change, regardless of how many products you create. This includes costs like:
- Machinery and equipment
- Web hosting
While fixed costs certainly have an impact on a business’s profitability, they don’t factor into the contribution margin.
Variable costs, on the other hand, will increase or decrease based on how many units you produce. This includes costs like:
- Raw materials
- Hourly workers’ wages
- Sales commissions
Once you know a business’s variable costs, you can calculate the contribution margin for each product on either a per-item or a percentage basis.
For example, let’s say that you’re producing 10,000 units at the factory. Your variable costs are $5,000 to produce those 10,000 units, which adds up to $0.50 in variable costs per unit. The customer pays $10 per unit.
In this case: Contribution margin = $10 - $0.50 = $9.50
That means the business has a $9.50 contribution margin per unit.
Contribution margin helps you understand how profitable a product is. Low margins mean that a business is spending too many resources on a product and isn’t earning enough to warrant production. You can calculate contribution margin to see if reducing costs or increasing the price of a product can improve profitability.