Contribution margin: understand its importance and how to calculate it
A key indicator of a company’s financial health, contribution margin enables managers to assess financial performance and formulate strategic plans. It gives a clear picture of the company’s potential for profit, which aids in the creation of future strategies that are more successful.
Want to understand how to calculate the contribution margin and why it is so important? We will show you!
What is contribution margin?
The amount that remains from a business’s total income after subtracting variable costs and expenses is known as the contribution margin. This sum is crucial as it helps the business make money and pays for fixed expenses.
As a financial indicator , the contribution margin can be calculated on a unitary or total basis, considering values from specific periods. Calculating this metric provides a broad view of the business’s financial health, allowing for more strategic and informed actions.
Importance of calculating the contribution margin
Regular calculation of the contribution margin is essential for managers to obtain accurate data, guiding decision-making and creating strategies to achieve the desired results. In addition, this metric has other important functions:
Financial indicator
The contribution margin helps in financial planning , allowing entrepreneurs to assess whether processes are in the red or in the black. It is a key indicator for analyzing profits in relation to specific products or services.
Strategic impact
It serves as the basis for corporate financial planning , to improve business strategies, facilitating decision-making based on information obtained about products and services. In this way, it is possible to decide what to keep, discontinue or review.
Stipulation of sales price
The contribution margin is crucial in defining sales strategies and budgets , as it is the basis for determining the Operational Break-Even Point (OBSP) and product pricing .
Types of contribution margin
Understanding the different types of contribution margin is essential for a more detailed analysis of financial performance:
- Unit contribution margin: calculated based on the sales price of a single product or service, indicating how much each one individually contributes to covering the company’s costs;
- The complete commitment edge is the distinction, short fixed costs, between absolute income and all out factor expenses and costs. Short-term choices pertaining to price, sales volume, and variable expenses are made using it;
- Contribution margin by channel: calculates the difference between the revenue and variable costs of a certain sales channel. ideal for companies that manage both physical and online storefronts;
- Businesses aiming to evaluate the individual performance of their sales teams might benefit from using contribution margin per salesperson as a beneficial statistic. It calculates each salesperson’s income after deducting variable costs.
How to calculate the contribution margin?
Calculating the contribution margin involves a simple formula, but it is necessary to understand what variable costs and expenses are:
- Costs: Expenses straightforwardly connected with the organization’s center business, like unrefined components and worker pay rates;
- Expenses: expenses that are not directly linked to production, such as rent and taxes .
Practical example
If a product is sold for R$10, with variable costs and expenses of R$7 per unit, and 100 units were sold in the month, we have:
- Contribution margin per unit: R$ 3
- Total contribution margin: R$ 300
This value indicates that, for each product sold, R$3 contributes to covering fixed costs and generating profit.
Contribution margin ratio
A business’ functional presentation not entirely set in stone by taking a gander at its commitment edge proportion, which shows the proportion of commitment edge to add up to income. The condition is:
(Commitment Edge/Complete Income) x 100 is the commitment edge proportion.
Practical example
If we have a margin of R$40,000.00 and total revenue of R$100,000.00:
- Contribution margin ratio = 40%
A higher index indicates greater operational efficiency.
How to improve the contribution margin?
For every manager, increasing the contribution margin is an objective. The following are some helpful actions:
Reduction of costs and variable expenses
Negotiate with suppliers and automate processes to increase productivity and reduce waste. Automation with ERP systems can be a great ally, allowing control and optimization of resources.
Reduction of fixed costs
Break down spending data to recognize regions where cash might be saved, for example, by moving to advanced records, recruiting outside help, and bringing down power bills.
Frequently Asked Questions (FAQs)
What is unit and total contribution margin?
The unit contribution margin is the profit generated by each product after covering its direct costs, while the total considers the overall profit of all units sold.
What is the formula for the contribution margin?
The amount available to pay for fixed expenses and turn a profit is calculated using the formula Total Revenue minus Total Variable expenses.