Contribution margin is a core business concept and is often used in cost accounting to identify the amount of financial contribution a sold product provides to the company. Simply put, contribution margin is the sales price less the direct costs (sometimes referred to as variable costs).
A parallel reporting format is the top two sections of a profit and loss (income) statement. Sales less costs of goods sold equals’ gross profit. Stated in a different way, price less variable costs equals contribution margin. However, in traditional accounting, the cost of goods sold section includes more than just the variable costs associated with the sale of the product. It is important for the reader to understand, contribution margin is a cost accounting concept; gross margin is a financial accounting concept. They are similar like cousins in a family; contribution margin is in the cost accounting family, gross margin is in the financial accounting family.
So why is the term so important to understand? How is it calculated? Where is it most appropriately used? The following sections answer these questions and tie the concept of ‘Contribution Margin’ to business.
Why you need to understand ‘Contribution Margin’
As a small business entrepreneur, you probably realize that there is more to business than just the sale of the product. There are a bunch of other costs to not only get the product to market but to run the business. There are monthly costs that never seem to stop, rent, utilities, communications, insurance, and office supplies. These types of costs are fixed in nature and don’t stop even if you are unable to sell a product. Then there are other costs such as marketing, transportation of the product, labor to make and sell the product. There are supplies needed to package and deliver the product to the customer. Those costs directly related to the product itself, i.e. they would not exist without the product being delivered to the customer are known as variable costs.
The sales price less the variable costs is referred to as the contribution margin.
As an owner of a business, you don’t make a profit until those fixed costs are paid first from the margin of the products sold. So if you only sell one product a month, then the contribution margin, i.e. the dollars left over from the sales price less the costs of that product, has to cover all the fixed costs of your business. Believe it or not, this is true for many businesses. Shipyards for example sell one to five ships per year. So they have to have enough contribution margin from the sale of a single ship to cover all the fixed costs at the yard.
This is why many people misunderstand car dealerships. The average person thinks that there is a lot of negotiating room in the price of the car because the dealer has a large markup on the car. Well, sure he does. He has to cover his fixed costs. Do you think his showroom rent is $500 per month? Your average small car dealership has between $25,000 and $100,000 per month in fixed costs. So if he only sells 25 to 100 cars per month, then his contribution margin can be no less than $1,000 per car.
As a small business owner, you need to understand that the contribution margin covers your fixed costs and your desired profit. Now you need to figure out how to calculate the contribution margin in order to cover your fixed costs and desired profit.
How to Calculate Contribution Margin
As the type of product sold heads towards greater sales volume, the contribution margin for the product can decrease to cover the fixed costs in the company. If the contribution margin decreases, the price can decrease too and in turn, more sales occur. So let’s do a simple equation to address a known item. Assume your fixed costs are $2,300 per month. The product (let’s call this a widget) you sell costs 72 cents to purchase the product, pay for the labor to make the sale, and get the product delivered to the customer. So how many widgets must you sell at $1.00 each to cover the fixed costs in one month? The formula is below:
N = Number of Widgets to Sell
C = Contribution Margin per Widget
F = Fixed Costs
Formula: N*C = F
Or in our case from above:
Number of Widgets to Sell * Contribution Margin of (1.00-.72) 28 cents = $2,300
N*.28 = 2,300
Therefore: N = 2,300.00/.28
N= 8,214 widgets
So based on the above, we don’t make a single dollar towards profit until we sell the 8,215th widget.
Let’s keep this simple and calculate the contribution margin per widget sold.
We are operating a vending business and all we sell is bottles of soda. So our variable costs include the following:
1. The cost of the bottle of soda
2. The cost to get that bottle delivered to the machine
3. The cost of the labor to load the machine
4. Since the consumer doesn’t pay a sales tax, the tax state we provide services in requires our business to pay a 5% vending license tax on every dollar or revenue unadjusted for the sales tax. In effect every dollar is considered revenue.
For the sake of simplicity, I’m going to assume the machines have no cost at all to us. We sell the bottle of soda for $1.50. We purchase the soda in volume and it is delivered to the business premises from the local distributing company at a cost of $.65 cents each. It costs around 18 cents per bottle to deliver the bottle to a machine (transportation costs). Furthermore, we use an automatic debit system at a cost of 1.82% to handle the money which is referred to as the discount fee. In effect, no machine takes coin or dollar bills; they are strictly modern debit/credit card transactions only. Finally, we pay a commission of 16 cents per dollar of net revenue (revenue less sales tax less the discount fee) for our labor. For the sake of simplicity, there is no employment tax or workman’s compensation insurance for this example.
So what are our variable costs?
Step One: Calculate the Sales Tax per Bottle of Soda – If a bottle of soda is sold at $1.50, then the sales tax variable cost equals $1.50 * 5%. This equals 7.5 cents per bottle.
Step Two: Determine the Discount Fee – the debit and credit card company charge a 1.82% fee on each dollar of sales or $1.50 * .0182 or 2.73 cents per bottle
Step Three: Labor to Load a Machine – Commission is 16 per cent of net revenue. Net revenue equals the total sales price less the vending tax of 7.5 cents less the credit card discount fee of 2.73 cents or ($1.50 – .075 – .0273) $1.3977 per bottle. Since net revenue is $1.3977; labor at 16% of net = 22.36 cents per bottle
Step Four: Add up the Variable Costs:
Cost per Bottle $ .65
Transportation per Bottle .18
Sales Tax .075
Discount Fee .0273
Total Cost per Bottle $1.1559
Now we calculate the ‘Contribution Margin’ per bottle sold:
Formula is Price less the Variable Costs or $1.50 less $1.1559 = $.3441 per bottle
How many bottles must we sell to cover our fixed costs? Well, first determine the fixed costs in your company. In almost all situations, the fixed costs are the total costs less the variable costs. So for this article, I am going to grab a fake number of $3,245 per month. So using the formula from earlier, the number of bottles to sell equals fixed costs divided by the contribution margin per bottle or for this situation, 9,430 bottles of soda per month to cover all fixed costs. If the owners desire a profit of $2,000 per month, we will need to sell an additional 5,812 bottles.
Now let’s look at from the financial perspective:
That’s a lot of bottles to sell! So how do we use this knowledge to help us in business?
Appropriate Use of Contribution Margin
The contribution margin is beneficial to us assuming we know we can sell the number of product (widgets) within a relevant range given the relevant price. To elaborate further, let’s continue with the example used above. Assume that the market will not pay $1.50 per bottle of soda. In reality, they will only pay $1.25 because it’s a small bottle of soda (12 ounces and not 16 ounces) or the market is very price conscious. So at a $1.25 per bottle, how many do we need to sell to cover fixed costs and the additional number to make the same profit?
Believe it or not, the formula has to be adjusted because the sales tax, labor, and discount fee are a function of the sales price. The cost per bottle and the price to transport are no different than above. So let’s look at the new variable cost formula at $1.25 sales price per bottle.
Did you notice a couple of issues? First off, the sales tax and discount fee is less. Secondly, the labor decreased in cost because labor is a percentage of sales. So this is important to understand. The physical function has not changed one bit, it is exactly the same as above but the guy doing the work gets 3.71 cents less per bottle to do exactly the same work. This is important because this is a significant decrease in your labor costs but at the same time from the labor perspective, you will not get the same quality laborer to get the work done.
So based on the new information; the contribution margin decreases to 14.83 cents per bottle of soda sold from 34.41 cents. The price decreased 25 cents per bottle and the variable costs decreased 19.58 cents per bottle. It is not a one to one ratio. In effect, there is a penalty to the business owner when decreasing the price. This is important to understand, if the variable costs decreased more than the price reduction, then it is beneficial to reduce the price. However, if the variable costs decrease at a lesser rate than the price reduction, it affects the number of units sold to cover the fixed and desired profit. The following paragraphs illustrate this effect.
To cover fixed costs, the business needs to sell 21,881 bottles of soda or more than double the sales from the $1.50 price tag. Actually, you need to sell 12,451 more bottles just to break even. To get the desired profit, you’ll need to sell an additional 13,486 bottles over the 21,881 bottles. In total, to cover fixed costs and profit, you’ll need to sell 35,367 bottles of soda whereas at $1.50 per bottle you only needed to sell 15,242 bottles. That’s 20,125 more bottles, more than double the sales at $1.50 per bottle.
Can a 25 cent decrease in the price generate an additional 20 thousand units of sales? Unlikely!
NOW YOU UNDERSTAND THE IMPORTANCE OF CONTRIBUTION MARGIN.
The contribution margin is instrumental in helping the owner determine the best price to sell his product.
The above is why you see bottles of soda for sale in vending machines at $2 to $3 each at your remote vending spots (rest stops on highways, vending sales at sport stadiums, etc.). Without proper contribution margin, the small business entrepreneur can’t cover his fixed costs and therefore will go out of business. This means to the consumer, no vending machines are present at these remote spots. Understanding the concept helps the small businessman price his product appropriately to cover his fixed costs. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.
The following article is a real life example of calculating the contribution margin of a single stroke in golf: The Cost of One Putt.