Launching new products or services is part and parcel of running a business, especially as it grows. But how do you know which are contributing most to your success? Calculating the contribution margin helps you to understand how successful different products are, which helps you make better decisions about your sales, marketing and budgets.
What is the contribution margin?
The contribution margin is what’s left when you deduct all variable costs from total sales revenue. For example, if a mug sold for £10 but the variable costs like materials, packaging and delivery cost £6, then the contribution margin for the mug would be £4.
“The contribution margin is a good metric to look at when you’re working out profitability as your business scales,” says Stephanie Marshall, Chief Executive of ABCS Consulting. “Gross profit margin is about the whole business over a particular period, but contribution margin helps in seeing the profitability of individual products or services.”
The contribution margin formula
To calculate the contribution margin, you must deduct your variable costs from your sales price:
Contribution Margin = Sales Price – Variable Costs
The above formula can be adjusted depending on what contribution margin is being calculated. For example, is the calculation per unit, for the whole company, or a specific product or service?
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The contribution margin ratio
Where the contribution margin is usually expressed in pounds and pence, the contribution margin ratio is expressed as a percentage. In this way, it provides a relative measure of profitability. This figure is obtained by dividing the contribution margin by sales revenue, using the following formula:
Contribution Margin Ratio = Contribution Margin (Total Sales Revenue – Total Variable Costs) / Selling Price Per Unit x 100
Expressing the contribution margin as a ratio or percentage makes it easier to understand and compare the various costs associated with different products and units.
For example, if a business sells their clocks for £50, and they know the variable costs are £10, then the contribution margin ratio would be:
Contribution Margin Ratio = (50-10) / 50 x 100 = 80%
This means that 80% of the revenue is available for fixed costs, while 20% of the potential profits are used for variable costs per unit.
Business benefits: why do you need it?
The main benefit of calculating the contribution margin is that it helps you as a business owner to understand your costs and profits for individual products or services. In turn, this means you can make more informed business decisions, especially around pricing.
Olives Et Al has been manufacturing olive-based products for 30 years, but in recent years, its variable costs have skyrocketed. “In January 2023, the price per tonne of olive oil was £3,000 but by the start of 2024 it was £9,600,” says Giles Henschel, the company’s Managing Director.
Tracking its contribution margins allowed Olives Et Al to evaluate each product line carefully to understand the impact of more expensive olives and olive oil. “We were operating on a contribution margin of 40% but on certain products, it was falling to unsustainable levels,” says Henschel.
Understanding costs
“Contribution margin helps you do a finer analysis of costs, compared to the cost of goods, because you’re looking at the cost to the business per unit, or per product line, or customer,” says Marshall.
For example, looking at the contribution margin and seeing it fall could help your business see where you need to cut costs. If you have a high contribution margin, you will have more capital to cover fixed costs as you scale your business.
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Making better spending decisions
If you can see that the contribution margin on a product is increasing, or if you see one product line has a negative contribution margin ratio, then you can take action to address the rising variable costs, perhaps by switching packaging suppliers or swapping suppliers of raw materials.
When Olives Et Al's costs rose, the company analysed the contribution margins for its major product lines. The result was that some product lines were withdrawn and became available only on demand. “If a customer wants to buy olives in extra virgin olive oil, we’ll make it, but we can’t offer it on the shelf at £10 a jar when it cost £5 a year ago,” says Henschel.
For other product lines, the company looked to reduce costs, by switching to a formulation using cold-pressed olive oil. Olives Et Al also ended its wholesale agreements, says Henschel. “We had been offering a discount of 30% to wholesalers on top of trade pricing, but that eroded our margins, so we just walked away from them,” he says.
Having the right pricing
Contribution margin is important when making choices around pricing and marketing, says Marshall. For example, if you have a target contribution margin across the company, it’s possible to make decisions around what to spend on marketing to optimise the customer acquisition cost and marketing budget.
Understanding profits
Keeping your eye on contribution margins means you can identify when to increase prices, adds Marshall. If you can see that variable costs are increasing and a contribution margin is falling, that could be a sign to review prices to maintain your overall profit margin.
Contribution margin vs gross profit margin
Contribution margin is similar to gross profit margin, but not the same. Where contribution margin is the money left after variable costs are deducted from sales revenue, gross profit margin is the total revenue minus the cost of goods sold (COGS), which includes both fixed and variable costs. This means you’ll also be deducting fixed costs such as lease costs, salaries and taxes, as well as variable costs.
Generally, gross profit margin is used in a company’s annual accounts, and is of more interest to investors, whereas contribution margin should be a regular feature in management accounts to support business decisions, says Marshall.
Common mistakes when using contribution margin
One of the key pitfalls of using contribution margin to support business decisions is not accurately tracking fixed and variable costs, says Marshall. “Fixed and variable costs aren’t always clear-cut, some costs might be debatable depending on how something is used, like is that car stock for a car dealership, or is it an asset being used by a driver to get to customer sites?”
It's also important not to view contribution margin in isolation, cautions Marshall. “There can be some cases where a product line has a low contribution margin but also low fixed costs that mean it delivers a relatively high net profit,” she says. “While contribution margin is useful for business owners, it’s far from a complete picture.”
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