For any business that sells products or materials should know about Contribution Margin. Understanding how contribution margins work can help a business not just break even, they can make a profit. A business should not lose money selling products or only break even. A business cannot thrive on those principles. Mark Dicus & Company would like to break down the basics of contribution margin and how it can help your business succeed.
What is Contribution Margin?
Contribution margin is basically a measurement of the remaining value of a sold product after subtracting the initial cost for the business to obtain the product. When a business buys materials or products from their supplier and then the business sells the product or materials to a customer, the leftover revenue is the contribution. The contribution from the sale will then go to the business’s profits. Not to get confused with net income, the contribution margin provides a better picture of your product’s value than the overall business numbers. With a proper view of your product value to your business, you can make better decisions of which products or material is helping or hurting the business. However, it is important for the total contribution margin to be properly calculated to ensure the products are actually valuable to the business, which is referred to as margin ratio.
How To Calculate Contribution Margin
When calculating a contribution margin you can use this simple formula: “Contribution Margin = Net Sales – Total Variable Expenses”. The total variable expenses are subtracted from the net sale. This will calculate the contribution margin. An example of a contribution margin calculation starts like this: When selling a $100 product and the variable cost of the product was around $35, your contribution margin will be $65. The golden rule for proper contribution margin is to make sure your contribution margin equals 65%. Calculating the contribution margin can be a lot of upfront work when formulating raw data on products. It is important to break down and categorize all of the expenses from the income statement into the variable and the fixed costs. As it can be hard to know how to categorize each of the expenses, an accountant and financial analyst can help classify the expenses. Once all of the expenses are properly categorized, it helps to better determine the contribution margin of each product.
How to Use Your Contribution Margin Data
With proper data on all of your products and other expenses, you can now use this information to better run your business. There are three major ways contribution margin can help, and the first is knowing you can add more products. When the business continues to grow and with enough profits you can add more products to continue the growth of the business. The second way contribution margin data can help is to also know when to remove products. If you are not making the 65% profit on your products, you may want to change products provided by the business. The last way you can use your contribution margin is to know when to adjust prices to your products. You don’t ever want to overcharge for products as customers will look for products at a better price. However, you don’t want your prices too low. You can make adjustments to the prices to sell the product more effectively.