Definition
Bookkeeping records are maintained in every single business, from small to large. However, to implement it is only half a task, it is also important to correctly use and evaluate this financial data. There is a special indicator that the management should be aware of, which is a contribution margin.
If you understand the importance of contribution margin and learn how to use it, you will gain the keys to increasing your business’s potential. Contribution margin is the amount of a business’s revenue left to cover the fixed costs or the money left after paying the variable expenses. Why consider only variable costs? After all, you have to cover both variable and fixed costs. Right?
This indicator is used to make decisions for the future. It might sound counterintuitive, but the variable costs per unit do not change much depending on how many units the company makes, so we can estimate them pretty closely. The fixed costs, though, are not guaranteed to stay the same or change a lot.
Profit and contribution margin are strategically important in business development. Thanks to these two indicators, it is possible to assess the efficiency of resource use and the financial result of the enterprise. Profit is the main goal of the business.
To find the amount of the profit, you need to deduct all costs from the sales revenue. The resulting figure is subject to taxation, after which the net profit is calculated. Thus, profit is the final value of the funds received by the entrepreneur from the sale of products and the payment of all associated costs. It is this indicator that reflects how successful the business is. The contribution margin, in turn, examines the profitability of a certain product or service.
Formula
This financial indicator can be found both on a gross basis, or you can compute this value on a per-unit basis.
This indicator, though, is generally represented as a percentage. To get that ratio, use the following formula.
How you can increase your contribution margin
To increase contribution margin, you need to focus on increasing the amount of total income and reducing variable costs. There are several strategies to achieve this:
- reduce variable costs by looking for the most favorable conditions when purchasing raw materials, introducing new technologies, and automating the processes;
- increase the price of a product by building trust in the brand, improving its quality of service. It is not advisable to constantly raise prices, but you can increase the production volumes, which will reduce overall costs and increase the share of profit in the structure of contribution;
- increase the share of products with the highest contribution margin.
Bottom line
With the help of contribution margin, it is possible to determine from what number of goods or services the company will receive a positive net income and become profitable. This is a very important indicator, especially if you are just starting your own business. It will help assess the competitiveness of the company and its product in the market. Evaluating contribution margin for different product or service categories allows you to highlight those that are in demand among customers and those that are not.
Margin analysis contributes to the efficient distribution of production capabilities and limited working capital, helps to optimize the composition and volume of production and sales of products, and to analyze the activities of individual divisions of the enterprise. It is also an integral part of pricing. In a global sense, based on the results of margin analysis, decisions can be made on the further development of the company or its closure.