The contribution margin is important data that helps understand and improve a company’s finances. These are some of the most important characteristics to be aware of. We will analyze its formula, application, and operating model.
In the internal calculation of the company’s finances, we do not always get the relationship between costs and the value of production right. Some metrics help us in these calculations. The contribution margin is one of the most important.
However, unlike other measurement tools in the company, in this case, it is usually not information that is made public. That is logical, as the cost to revenue ratio is where the company’s profit lies. Generally, companies want to hide their cost-to-revenue data and their strategies in this respect from their competitors.
What is the contribution margin?
The contribution margin is the company’s sales revenue minus variable expenses in a simple definition.
Usually, the results obtained (in dollars) can cover fixed expenses, and the excesses are considered profit. When presented in dollars or as a percentage, this margin can indicate different values or records, from a total amount to a product line or even a production unit.
What is the contribution margin formula?
That is a formula that is not complex. It is calculated by subtracting the number of variable costs from the net sales revenue. This gives the contribution margin.
Some variables can be calculated by adding the fixed costs plus the net profit, although this is more complex and oriented towards industrial production.
Instead of obtaining a number in dollars, what we are trying to get is a proportion, i.e. an index; the formula would be as follows: the result of subtracting variable costs from net sales revenue divided by the price per unit.
Why are variable costs so important?
Variable costs are the key determinant in determining the contribution margin. If the formula for the contribution margin is simple, the really difficult part is calculating the variable costs.
A variable cost is any direct or indirect expense that a company has when it manufactures, produces, or sells a good or service. Variable costs can be influenced by the number of units for services rendered and other factors such as seasonality, seasonality, or even lack of raw materials.
However, in a perfect model, the time cost would only be the one that is influenced by the increase or decrease in productivity. However, this is unlikely in today’s world, where markets strongly influence variable costs.
For example, if we manage a chain of hairdressing salons and we know that in the months leading up to the summer, we have a huge increase in requests for hair washing and haircuts, we also understand that the amount of shampoo we will have to use will increase. In this case, shampoo is a variable cost.
This cost is modified by the increase in the number of services we have provided, but also by seasonality as in the spring we will do more pre-summer cuts than at other times of the year.
What can be considered a variable cost?
It is important to understand that variable cost is not the same for everyone. We can find An example of this in services and supplies.
If we continue with the example of the hairdressing salon, the amount of water consumption during the peak period of services will be higher than at other times of the year. Therefore, in this case, the cost of water could be variable. However, in a bank office, the price of water would remain unchanged because it would not have significant peaks in consumption. In this case, it would be a fixed cost.
However, some elements that can be considered as variable costs are the following:
- The raw materials you will use in production.
- Supply items needed for your products or services
- Costs per unit of labor, including wages and other related costs
- Marketing costs, including commercial commissions, etc.
- Shipping and transport costs
What can be considered a fixed cost?
As we have seen before, in some cases, the borderline between a fixed cost and a variable cost is somewhat blurred. A fixed fee will not depend on what you produce or what you sell, as it will always maintain a more or less regular price.
Examples of fixed costs could be:
- Rental or depreciation costs of buying premises.
- Fixed wages (when not directly linked to productivity)
- Taxes based on the value of the property
- Utilities, when consumption is not related to products or services
- Interest and financial depreciation
Why is the contribution margin so important?
That is a top-level metric in the business world. Note that when a company is pricing its products or services, contribution margin is one of the most commonly used levels of measurement.
Generally, a high contribution margin will be considered adequate as it will assume the possibility of covering fixed and variable costs while leaving room for profit.
When metrics are calculated and contribution margins are low or negative, a product or service’s price/cost ratio may not be profitable. In this case, companies make strategic decisions that can range from increasing prices to trying to reduce costs.