To understand how profitable a business is, many leaders look at profit margin, which measures the total amount by which revenue from sales exceeds costs. But if you want to understand how a specific product contributes to the company’s profit, you need to look at contribution margin, which is the leftover revenue when you deduct the variable cost of delivering a product from the cost of making it. To calculate this figure, you start by looking at a traditional income statement and recategorizing all costs as fixed or variable. This is not as straightforward as it sounds, because it’s not always clear which costs fall into each category. And this is where most managers get tripped up. But going through this exercise will give you valuable information. Analyzing the contribution margin helps managers make several types of decisions, from whether to add or subtract a product line to how to price a product or service to how to structure sales commissions. But never look at contribution margin in a vacuum. Before making any major business decision, you should look at other profit measures as well.
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When you run a company, it’s obviously important to understand how profitable the business is. Many leaders look at profit margin, which measures the total amount by which revenue from sales exceeds costs. But if you want to understand how a specific product contributes to the company’s profit, you need to look at contribution margin.
To understand more about how contribution margin works, I talked with Joe Knight, author of HBR Tools: Business Valuation and cofounder and owner of business-literacy.com, who says “it’s a common financial analysis tool that’s not very well understood by managers.”
What Is Contribution Margin?
Knight warns that it’s “a term that can be interpreted and used in many ways,” but the standard definition is this: When you make a product or deliver a service and deduct the variable cost of delivering that product, the leftover revenue is the contribution margin.
It’s a different way of looking at profit, Knight explains. Think about how company income statements usually work: You start with revenue, subtract cost of goods sold (COGS) to get gross profit, subtract operating expenses to get operating profit, and then subtract taxes, interest, and everything else to get net profit. But, Knight explains, if you do the calculation differently, taking out the variable costs (more on how to do that below), you’d get the contribution margin. “Contribution margin shows you the aggregate amount of revenue available after variable costs to cover fixed expenses and provide profit to the company,” Knight says. You might think of this as the portion of sales that helps to offset fixed costs.
How do you calculate it?
It’s a simple calculation:
Contribution margin = revenue − variable costs
For example, if the price of your product is $20 and the unit variable cost is $4, then the unit contribution margin is $16.
The first step in doing the calculation is to take a traditional income statement and recategorize all costs as fixed or variable. This is not as straightforward as it sounds, because it’s not always clear which costs fall into each category.
As a reminder, fixed costs are business costs that remain the same, no matter how many of your product or services you produce — for example, rent and administrative salaries. Variable costs are those expenses that vary with the quantity of product you produce, such as direct materials or sales commissions. Some people assume variable costs are the same as COGS, but they’re not. (When you subtract COGS from revenue you get gross profit, which, of course, isn’t the same as contribution margin.) In fact, COGS includes both variable and fixed costs. Knight points to a client of his that manufactures automation equipment to make airbag machines. For this client, factory costs, utility costs, equipment in production, and labor are all included in COGS, and all are fixed costs, not variable.
“Some parts of operating expenses, which we assume are fixed, are in fact variable,” he says. “The costs of running the IT, finance, and accounting groups are all fixed, but, for example, the sales force may be compensated with commissions, which would then be considered variable.”
Doing this calculation right takes “a tremendous amount of work, and it is critical that you are consistent in your breakdown of fixed and variable costs over time,” Knight says, but the information you gain from looking at profitability at the product level is often worth the effort.
How Do Companies Use It?
Analyzing the contribution margin helps managers make several types of decisions, from whether to add or subtract a product line to how to price a product or service to how to structure sales commissions. The most common use is to compare products and determine which to keep and which to get rid of. If a product’s contribution margin is negative, the company is losing money with each unit it produces, and it should either drop the product or increase prices. If a product has a positive contribution margin, it’s probably worth keeping. According to Knight, this is true even if the product’s “conventionally calculated profit is negative,” because “if the product has a positive contribution margin, it contributes to fixed costs and profit.”
“Some companies spend a lot of time figuring out the contribution margin,” he says. It requires that a managerial accountant dedicate time to carefully breaking out fixed and variable costs. For firms like GE, there is a big focus on looking at products “through a contribution margin lens.” This is important to the company because GE is “a disciplined firm that works in very competitive industries and wants to cut out nonproductive products.” So it prunes the ones that don’t have a high contribution margin.
It’s likely that a division leader at GE is managing a portfolio of 70-plus products and has to constantly recalculate where to allocate resources. “As a division head, if I have to cut, I’m going to cut products that have the lowest contribution margin so that I can focus resources on growing the business and increasing profit,” Knight says.
Of course, GE has a lot of resources to dedicate to this analysis. But it’s not just the GEs of the world that should be considering this figure, Knight says: “Every company should be looking at contribution margin. It’s a critical view on profit, in large part because it forces you to understand your business’s cost structure.”
What Mistakes Do People Make?
Knight says that there are “so many ways you can make a mistake,” all of which stem from the fact that “costs don’t fall neatly into fixed and variable buckets.” He warns that there are some costs that are “quasi-variable.” For example, you might add an additional machine to the production process to increase output temporarily. This falls in between the two categories, since it could be considered an additional cost due to the higher production (and therefore variable), or it could be thought of as a fixed cost since it’s a one-time purchase that doesn’t fluctuate with the amount of product you’re producing. Sometimes certain salaries could be looked at this way as well. “The financial analyst makes a distinction that requires a judgment call on where to classify these salaries,” Knight says. R&D expenses are also subject to scrutiny. “They are sometimes considered fixed costs, while others look at them as direct costs associated with the product. Your contribution margin could be dramatically different because of how these costs are categorized.”
Another mistake that some managers make is to assume that you should cut the lowest-contribution-margin products. But you shouldn’t use contribution margin, or any measure of profit, exclusively; you should consider the fixed cost allocation as well. Take a company’s cash cows, a term coined by the Boston Consulting Group to describe products that provide a steady income or profit. Generally these products require very little support; you don’t have to invest in sales or do any R&D support. And yet cash cows generally show up as having a low contribution margin because they can have high variable costs while not drawing on the company’s fixed costs. However, you wouldn’t necessarily want to cut them as a result; “you have to consider the cost of supporting a product” and “how much of the company’s fixed costs is associated with the product,” Knight explains. “When you find that these low-contribution-margin products fill a product line or are a barrier to entry for a competitor, you should probably consider keeping the product around.”
Looking at contribution margin in a vacuum is only going to give you so much information. Before making any major business decision, you should look at other profit measures as well.
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