How To Calculate the Contribution Margin Ratio
Along with the company management, vigilant investors may keep a close eye on the contribution margin of a high-performing product relative to other products in order to assess the company’s dependence on its star performer. Fixed costs are often considered as sunk costs that once spent cannot be recovered. In this case, the business would have to take a look at its variable costs and see if any changes could be made to cut costs and increase the marginal profit per unit of sale.
Instead, consider using contribution margin as an element in a comprehensive financial analysis. You can also use contribution margin to tell you whether you have priced a product accurately relative to your profit goals. These can fluctuate from time to time, such as the cost of electricity or certain supplies that depend on supply chain status. Fixed costs are one-time purchases for things like machinery, equipment or business real estate. Below is a breakdown of contribution margins in detail, including how to calculate them.
How do gross margin and contribution margin differ?
You can use a spreadsheet, such as Google Sheets or Microsoft Excel, to include columns by product, enabling you to compare the contribution margin for each of your business products. There’s not necessarily one “good” gross margin that companies should strive for. A high gross margin might not necessarily mean a company is performing well, while a low gross margin might not mean a company is performing poorly. The product may also provide very steady profits and require very little investment to keep selling. This can be particularly useful in comparing different products and understanding how profitable a certain product may be relative to another. It provides an accurate and actionable look at profitability from product to product, but it shouldn’t be considered in a vacuum.
Typical variable costs include direct material costs, production labor costs, shipping supplies, and sales commissions. Fixed costs include periodic fixed expenses for facilities rent, equipment leases, insurance, utilities, general & administrative (G&A) expenses, research & development (R&D), and depreciation of equipment. A company’s contribution a very low contribution margin is indicative of margin shows how much revenue is available after it deducts variable costs like raw materials and transportation expenses. The primary difference between the two comes down to what costs are considered in the calculation. Gross margin is calculated as sales revenue minus cost of goods sold (COGS), and then divided by sales revenue.
