Accounting 101 tells us that contribution margin is calculated as follows:
Contribution Margin = Sales Revenue – Variable Costs
Understanding each products contribution is critically important when running a lean operation that I seek to maximise profits.
Because analysing your contribution margin as part of your financial reporting helps identify areas for improving overall gross margin and operating profit.
Let’s take a step back…what is contribution margin?
Basically, it is the money generated for each product after variable costs have been deducted. As a metric, it helps manufacturing companies identify product lines or areas within the business that are underperforming.
It’s important to note that this is different from gross margin. While they look at the same information, they each take a slightly different perspective. Gross margin calculates the amount of money that is left after direct costs, whilst contribution margin examines the amount of profitability in each product or unit.
Contribution Margin is a per-item metric.
So, how do we categorise this?
Contribution margin ultimately breaks costs into categories. This allows the business to assess what gross margin each product or service contributes to the total in the business.
This is important because a company may have a gross margin that is healthy and on target, yet individual products are not performing on a comparative level.
For example, cost categories of contribution margins could be:
- Cost of goods sold by product or category of a product
- Production costs for manufactured goods
- Labour costs by service activities
By analysing the individual elements of a product line, a company can measure, analyse and cut (or improve) underperforming lines. Which will increase the overall Gross Margin and Operating profits of the business.
An example of this
The large scale air conditioning manufacturing company, ‘Cool Guys’ makes $30,000 in revenue for every unit they sell of category X coolers. The variable costs to complete this installation are $16,000.
NOTE: Variable costs increase in direct proportion to the number of units of the product being manufactured. For example; labour, raw materials & delivery costs.
To calculate the contribution margin of this scenario:
$30,000 (revenue) – $16,000 (variable costs) = $14,000 (contribution margin).
Now, as contribution margin is commonly referred to as a percentage, we simply divide the result by the revenue and multiply by 100. So in this scenario, the contribution margin is 46.6%.
We now have a figure that is directly comparable to any other product or category of product in the business.
Creating a comparative model
For businesses that manufacture or distribute multiple products across multiple categories, you can begin to see how calculating this figure and comparing will allow you to identify the areas that are performing best and those lines that either need to be cut or improved.
This will then lead to improving gross margin and operating profit.
Where do you start?
To track Contribution Margin across your business systems, we need to track cost of goods and product costs at the product item code level all the way through to the accounting system.
Enterprise Resource Planning (ERP) is key to achieving this. The success in calculating not only Contribution Margin, but other key metrics comes down to visibility across areas of the business. From sales, to accounting, to floor staff and so on, you need to have visibility.
Systems that are not integrated run the risk of using outdated or wrong data, which could impact decisions related to improving operating profits.
At Klugo, we know that increasing profit is the goal of any project we undertake. But in order to achieve this, every business needs to implement systems that help measure core metrics in real-time. Once visibility is achieved, the process of improving profitability becomes an easy process.
NetSuite + NextService
Klugo’s vision is to unlock the full operating potential of our customers to maximise the value of their business. We do this by helping our customers achieve operating excellence using NetSuite + NextService, the world-leading cloud ERP and FSM business platform for small-to-medium-sized businesses.
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