So, you’re a small business owner and you wanna know exactly how much you’re earning in profit each month or year. Great! That’s not what contribution margin is for.
Nope. Contribution margin is more so used to measure the profitability of individual products or services you sell. Why would you wanna know that? Well, it can certainly help in identifying which products you offer that are worth your time, energy, and investment.
However, investors might also use contribution margin to figure out how much of your profitability is coming from one product or another. Either way, it’s a great metric to measure as a business owner growing a business. And, understanding what contribution margin is can help you learn where to focus your efforts and budget.
Read along as we explain contribution margin, walk you through a real-life scenario, and talk about the various situations in which you might need to use it.
Already know all about contribution margin and just want to increase the value of your business? We can help! Click here to learn more about the Wealth Stack Growth Pack.
Contribution Margin Explained
Contribution margin is the difference between your sales revenue and variable costs, and it’s represented as either a dollar amount or a percentage. What’s left over when you calculate contribution margin should be used to cover fixed costs like rent, payroll, etc. Everything left over after that is considered pure profit. Ideally, the closer to 100% you are, the better! However, it’s pretty unfeasible that any business in any industry is going to be able to have a 100% contribution margin.
Does this mean that contribution margin is the same as profit? Not really, no. Usually, when you’re calculating gross profit margin, for example, you’re trying to figure out how much a business has left after deducting the costs directly related to producing a product. Contribution margin factors in all variable costs, and it’s more a measure of the profitability of various individual products rather than of your entire business as a whole.
Formula for Contribution Margin
What’s the formula for contribution margin? You can calculate it a few ways. The easiest way to calculate contribution margin would be the following:
Net Sales Revenue - Variable Costs = Contribution Margin
Depending on why you’re calculating contribution margin, the ratio might be a little more accurate or useful to you. You can calculate contribution margin ratio with the following formula:
(Net Sales Revenue - Variable Costs) / (Sales Revenue) = Contribution Margin Ratio
To make this all a little easier to understand, let’s break this down with a real-life example. Let’s say you’re a business owner who sells t-shirts. Last month, you sold 50,000 t-shirts, and while the selling price of each shirt was $20, the variable manufacturing costs were $5 and the variable expenses for administrative fees and sales was also $5. This means that the contribution margin for each t-shirt is $10. Likewise, the contribution margin ratio would be .5 or 50%.
Gross Margin vs. Contribution Margin
What’s the difference between gross margin and contribution margin? Really, in what you’re measuring. Contribution margin is used to measure the profitability of specific products or items. Gross margin is your total profit across all items and services offered.
This is why you focus so much on variable costs when measuring contribution margin. With gross margin, you’re simply deducting all costs and expenses from your revenue to find your profit margin. With contribution margin, you’re factoring in the variable costs it takes to produce one item, for example. In that case, you need to think about variable costs such as per unit labor, the cost of the raw materials needed to produce the item, and production supplies.
Therefore, we don’t recommend using contribution margin to measure your company’s general profitability. In fact, here’s how we suggest using contribution margin to benefit your business…
How to Use Contribution Margin in Business
How can you use contribution margin to increase the value of your business? As we mentioned before, it’s particularly helpful for those who offer a variety of products. If you produce a variety of products, for example, that are all fabricated in the same production plant, you can use contribution margin to evaluate which product is ultimately the most profitable for your company.
Depending on your overall business profits, it might make sense to discontinue the production and sale of one product and focus only on the more profitable one.
Likewise, investors might look at the contribution margin of your product offerings as well. Why do they care if you’re profitable? If you offer 10 products but one of them is responsible for 80% of your profits, it can be a bit risky to invest in your business. For example, if there are supply chain issues with the ingredients or supplies needed to create that product, or if demand suddenly drops, your business will become very unstable very quickly.
Increase the Value of Your Business with Wealth Stack
Increasing the value of your business starts by looking at the details. If you offer products, understanding what contribution margin is can help you start to analyze which products are helping you earn the majority of your profit and which ones might be better to discontinue. However, outside of that, you might find that you need access to more resources that can help you scale.
The Wealth Stack Growth Pack offers you the ability to access those kinds of resources, including the following digital advisory services:
- The tools and resources you need to learn how to invest in your employees, attract and retain top talent, and access the funding you need at the terms you want
- Exclusive access to our founder and a former investment banker who will personally assess your business to help you increase its value
- Access to a platform where we will provide you with capital introductions to investors and alternative sources of funding
Did we mention that we offer access to the platform at a fraction of the cost you’d find for other similar services? Click here to become part of the Wealth Stack Growth Pack and to learn more about how we can help you grow your business.