What is Contribution Margin?
Contribution Margin is a useful concept to analyze the cost structure of your company,
to figure out what kind of volumes you need to make your business worthwhile.
Contribution Margin.
The word margin indicates that it is a term describing profitability.
The word contribution in this context means contributing to covering fixed costs.
Once Contribution Margin has fully covered fixed costs, a company can turn profitable.
To understand Contribution Margin,
it is important to understand variable costs and fixed costs first.
Variable costs and fixed costs are a simplification of reality that assumes that costs can be
categorized in just two categories: they either move up with the number of units sold (which
is called variable costs), or they don’t (which is called fixed costs).
Typical textbook examples of variable costs are materials used in production, factory
labor, and electricity needed to run a production machine.
Typical textbook examples of fixed costs are depreciation, and the “readiness to serve”
costs of support staff such as HR or finance.
In real life, things tend to be more messy than in a textbook.
Variable costs are more variable than expected, they do move up with the number of units sold,
but not in a fully linear straight-line way.
Fixed costs are largely indifferent to the number of units sold, but might have some
“step wise” increases.
Let’s stick with the idealized textbook definitions in this video, but don’t say
I didn’t warn you when you try to apply
the Contribution Margin concept in your own business!
Contribution Margin per unit.
In the toy giraffe company, every unit is sold at $10.
The variable costs (material, labor, electricity) to make a unit are $6.
Therefore, the Contribution Margin is $4, or 40% of revenue.
Each incremental toy giraffe that is produced and sold contributes an extra $4 to cover
fixed costs.
What does the Contribution Margin look like in total when we produce and sell 1000 units?
Revenue will be $10,000, variable costs $6,000, and Contribution Margin $4,000.
We have $4,000 of Contribution Margin available to cover fixed costs.
Unfortunately, the fixed costs are $200,000, so $196,000 of fixed costs are not covered
by the Contribution Margin.
The company makes a loss (at the Operating Margin level) of $196,000.
Let’s 10x this business!
We produce and sell 10,000 units.
Revenue will be $100,000, variable costs $60,000, and Contribution Margin $40,000.
We have $40,000 of Contribution Margin available to cover fixed costs.
Unfortunately, the fixed costs are $200,000, so $160,000 of fixed costs are not covered
by the Contribution Margin.
The company makes a loss (at the Operating Margin level) of $160,000.
We need to produce and sell more units!
How about 50,000 units?
Revenue will be $500,000, variable costs $300,000, and Contribution Margin $200,000.
We have $200,000 of Contribution Margin available to cover fixed costs.
As the fixed costs are $200,000,
the fixed costs are now completely covered by the Contribution Margin.
The company generates an Operating Margin of zero.
When we produce and sell more than 50,000 units, the business will be in the win zone!
How about 100,000 units?
Revenue will be $1,000,000, variable costs $600,000, and Contribution Margin $400,000.
We have $400,000 of Contribution Margin available to cover fixed costs, which is more than enough!
Once fixed costs are covered, Contribution Margin starts contributing to profitability.
The company makes a profit (at the Operating Margin level) of $200,000.
Contribution Margin.
The word margin indicates that it is a term describing profitability.
The word contribution is related to contributing to covering fixed costs.
Once Contribution Margin has fully covered fixed costs, a company can turn profitable.
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