Contribution margin is one of the most important metrics to measure for your products and services. It helps you compare the competitiveness of your products and helps you decide whether it is worth keeping, deserves a new price, or can be safely dropped.
What is contribution margin?
Shipping in bulk increases the contribution margin. Image source
Every product and service comes with its own costs, which are necessary to offer them in the first place. Accounting for the costs is important as this allows us to determine the profitability of a product or service.
One way to quantify the profitability of a product or service is the contribution margin. Contribution margin is simply defined as the difference between the revenue and the associated variable cost:
Contribution margin can also be expressed as a ratio:
The contribution margin can be calculated either in bulk or per piece of product or service offered. For the latter, the contribution margin per piece can be calculated as follows:
What is variable cost?
Contribution margin is defined with the variable cost in mind. Variable cost includes the following, for the case of products:
Production costs: The raw materials may change their price over time.
Shipping costs: As the shipping costs are strongly tied to the price of oil, any change in its prices can significantly affect the resulting shipping costs. Note that the shipping cost that is displayed in the checkout screen when someone orders online is not included here as it is shouldered by the customer.
Storage costs: For products that have to be stored in specialized facilities such as perishable goods, the storage costs would depend not just on the maintenance costs such as energy costs but also on the amount of goods being stored, as these can be adjusted to conserve energy.
Commission-based labor costs: Certain businesses offer commissions for each successful purchase. These can vary over time.
For services, variable costs include the following:
Hosting and maintenance costs: You need to spend for the hosting of your services, whether you host it in an external cloud or you run your own servers. Additionally, as you grow your customer base, you need to scale up your cloud subscription or expand your own servers.
Commission-based labor costs: Certain businesses offer commissions for each successful purchase. These can vary over time.
Some of these costs may be calculated individually, such as sales commissions for every successful purchase, or calculated for bulk, such as the shipping of a set of products to the store.
Why should you calculate contribution margin?
The main purpose of contribution margin is to find the break-even point. The variable costs generally increase with an increasing amount of products being produced. However, the variable cost per unit may actually decrease per unit as the amount of products being produced increases. To find the ideal amount of units to produce, the contribution margin must be calculated. The break-even point is the minimum amount of units you need to sell in order to recoup the costs you incurred in producing your product. It can then be used as a sales target for a specific period of time.
There are two additional reasons you should calculate the contribution margin of each product or service you offer:
To see if the product is priced correctly: A positive contribution margin means you earn more from the product than you spend to create it. A negative contribution margin, however, means that you are losing money while producing it. In that case, you should consider raising the price of that product.
To see if the product should still be offered: The contribution margin can also be used to compare the profitability and competitiveness of your products, as contribution margin factors in costs that depend on the volume of its sales (such as shipping and storage costs). Products with high contribution margin should be kept while products with low contribution margin (if not negative) should be either revamped or no longer be offered.
These two questions are best analyzed by also considering the amount of units sold for a given time period. For products that have high sales volume but low contribution margin (or negative), this is the right time to increase the prices reasonably! But for products that have low sales volume and low contribution margins, you can consider dropping the product altogether.
How can you improve your contribution margin?
Here are some tips in improving your contribution margin:
Increase the price: Increasing the price not only increases your sales but also the subsequent revenue and profit. However, tread carefully when doing this, as it can easily dissuade customers from buying your products. Conduct market research to make sure a price increase will work.
Boost your sales: A lot of variable costs per item go down when you increase the volume produced. To do so, you should increase your sales. One way of doing so is to launch marketing campaigns at various platforms. Here are some of our existing blog posts that can help you get started:
Reduce production, maintenance, and shipping costs: For products, reducing the production costs can increase the contribution margin. As production costs include raw materials and operational costs, there are ample opportunities to reduce the costs which can include switching to cheaper sources, using newer machines for more efficient productions, or, in the case of businesses that outsource production, looking for better suppliers and ordering in bulk. Shipping cost per unit can also be reduced when you ship products to your stores in bulk or even switch to a cheaper service for the tradeoff of a slower delivery. For services, the maintenance costs can be reduced when you properly scale your cloud according to the demand for your services.
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