What is contribution margin?
A 'contribution margin' is a cost accounting metric used to assess the profitability of a product, service, or business segment. The contribution margin represents the portion of a company's sales revenue available to cover fixed costs and contribute to profits. Essentially, it shows how much each unit sold contributes to covering both variable and fixed costs.
But let’s pull back a little and consider some essential definitions:
Sales revenue: the total revenue generated from sales of a product, service, or business segment.
Variable costs: costs directly associated with producing or providing the product or service. Variable costs increase as production or sales do, and unsurprisingly, decrease as production or sales decrease.
A high contribution margin means a significant portion of the sales revenue is available to cover fixed costs and generate profit, while a low margin suggests revenue is being consumed by variable costs ― leaving less to cover fixed costs and contribute to profit.
Contribution margin analysis can help to inform pricing decisions, optimize the product mix, and assess the overall financial health of a business.
What’s the difference between contribution margin and income statement?
Contribution margin and income statements are related, but serve different purposes and provide different insights into a company's financial performance. Let’s examine the key differences:
Purpose: As mentioned earlier, the primary purpose of the contribution margin is to assess the profitability of individual products, services, or business segments. The income (or profit and loss) statement provides a comprehensive summary of a company's financial performance over a particular period, and includes all revenues and expenses ― not just those related to production or variable costs. Its primary purpose is to report the overall profitability of the entire company, considering all revenue sources and expenses.
Scope: Contribution margin is typically applied at a more granular level, while the income statement provides a broader overview of a company's overall financial performance.
Components: The contribution margin consists of the sales revenue and variable costs associated with a particular product, service, or business segment, while the income statement includes all revenues (such as sales, interest income, and other income) and expenses (including both variable and fixed costs, taxes, interest expenses, and more).
Time period: The contribution margin can be calculated over any time frame, but is generally used for short-term decision-making. By contrast, the income statement typically covers a specific accounting period ― such as a month, quarter, or year ― and provides a comprehensive view of a company's financial performance over that period.
How to calculate contribution margins
You can calculate the contribution margin with the following formula:
Contribution Margin = Sales Revenue - Variable Costs
Here's a step-by-step guide:
- Determine sales revenue. Make sure you use the revenue specifically associated with the product or segment you’re analyzing.
- Calculate variable costs. Again, calculate the total variable costs for the product or segment you're interested in.
- Apply the formula. Subtract the total variable costs from the sales revenue.
Express the contribution margin as a percentage. If you want to express the contribution margin as a percentage, you can use the following formula:
Contribution Margin Percentage = (Contribution Margin / Sales Revenue) x 100
What is a good contribution margin?
What constitutes a ‘good’ contribution margin varies widely depending on industry, business model, and other factors. A 'good' contribution margin is relative, and should be considered in the context of your business and its objectives.
Generally, a higher contribution margin is preferable as it means that a larger portion of sales revenue is available to cover fixed costs and contribute to profit.
Ultimately, what constitutes a good contribution margin for your business depends on your specific goals, cost structure, and competitive landscape. It's important accounting teams to benchmark contribution margin against industry standards and own historical performance, as well as to consider the trade-offs between margin and other business factors like market share and growth.'
