What is Contribution Margin and Why Should You Care?

Whether you head a multinational corporation or you manage your toddler’s lemonade stand, monitoring contribution margin is the difference between making a profit and having to fire your toddler.
 
Let’s discuss the significance of the contribution margin and how it relates to the profitability of your business. 

What is the contribution margin?

Investopedia defines contribution margin as the incremental money generated for each product/unit sold after deducting the variable portion of the firm’s costs.
 
With this consideration, the contribution margin is one of the best ways to evaluate the profit potential of a product!

How do you calculate the contribution margin?

The contribution margin of a product can be calculated by subtracting the variable cost per unit by the sales price per unit.
 
Contribution Margin = P – VC
Suppose your toddler’s lemonade stand sells 1 glass of lemonade at $5.00 and the variable cost of the product is $1.50. By plugging in the formula above, we can subtract $5.00 – $1.50 and find that the contribution margin in $3.50!
 
Sounds like a profit — your toddler gets to keep their job!
 
Notice, this does not take into account for any fixed costs that the lemonade stand has to pay off. Due to the fact that the contribution margin is meant to determine the profit potential of a product, the formula ignores costs that exist whether or not the product is created or sold, such as overhead or rent costs.

The Relationship between Contribution margin and breakeven

The breakeven point is when revenue equals all business costs and, as such, is a significant consideration for any business – even a simple lemonade stand. 
 
If your toddler’s lemonade stand makes $100 daily, but it costs $100 to keep up daily, you reached your breakeven point. Granted, your toddler won’t probably stress out about it — they’ll just shrug their shoulders and watch some cartoons.
 
But wait, what does this have to do with contribution margin? The breakeven point can be calculated by dividing total fixed costs by the contribution margin per unit.

 

Breakeven Point = 

Total Fixed Costs / Contribution Margin Per Unit

By calculating the breakeven point, you can evaluate whether or not you’re currently making a profit and understand areas of opportunity and growth. Contrastingly, you may also come to the realization that you may have to lay off your own toddler…. yikes.

Conclusion

The contribution margin is one of the most important considerations you can make regarding the profitability of a product. If you can calculate the contribution margin, you position yourself to better understand your product, it’s profitability, and potential changes you need to make, such as the price of your product, your pricing negotiations with your manufacturing partners, or the product line itself. Supplementarily, the breakeven point can help you better understand the goals and KPI’s you require to make a profit. 
 
Keep these in mind and your toddler will always have a place in your lemonade stand.

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