Contribution margin is a financial calculation used to determine individual products' contribution to a company's overall profitability. Although contribution margin is usually geared toward individual products, this calculation also can be used to shed light on the profitability of individual departments, business units or brands. Calculating contribution margin requires only two variables, but both variables can be challenging to quantify. Understanding what is needed to calculate contribution margin, as well as the contribution-margin formula, can take your product-planning decisions to the next level.
The first variable to consider is product revenue, or revenue from the specific department, business unit or brand under consideration. To calculate the value of individual product revenues, you must break total income down into its various component parts. Income statements can be virtually useless to determine product revenue; this information is most readily available from internal accounting and inventory records. For example, a company's income statement may list a total revenue of $1 million. Looking into inventory records, a manager may discover that the company has sold 10,000 units of Product A, which is priced at $25. Multiplying the number of units sold by the unit price, the manager can determine that sales of Product A comprised $250,000 of the $1 million total.
Product Variable Costs
The second variable in the contribution margin formula is product variable costs. Determining variable costs for individual products should be fairly simple if you have kept adequate accounting records. Company accountants should be able to calculate cost of goods sold (COGS) data quickly using an accounting software package with up-to-date information. Calculating variable costs for entire departments, business units or brands can be more challenging than determining COGS for individual products. When calculating variable expenses on a larger scale like this, make a list of all of the costs that go into the area in question and separate costs that vary according to production volume from costs that remain the same regardless of volume.
Calculating Contribution Margin
Use the following formula to calculate contribution margin on a percentage basis: (product revenue -- product variable costs) / product revenue Use the following formula to calculate contribution margin based on total profit: product revenue -- product variable costs To continue our example, suppose that Product A incurred variable costs of $12 per unit. Selling 10,000 units at a cost of $12 and a selling price of $25 would incur $120,000 of variable costs and bring in $250,000 of total revenue resulting in a contribution margin of 52 percent ( ( 250,000 -- 120,000 ) / 250,000 = .52 )
Calculating gross profit margins and net profit margins can provide more big-picture insights compared to contribution margin. Gross profit considers the contribution margin of all products, services and business units, while net profit calculates the amount left over after all company expenses are taken into account. Savvy managers use all three metrics to gain a more comprehensive understanding of their companies' profitability.
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