Financial Explainer — contribution margin

This blog is part of a finance series and is designed to help small businesses get to grips with their financial statements. We break it all down and explain each part in simple terms.

In this instalment, we're going to talk about a type of profit margin — your contribution margin.

This margin is a measure of the profit you make on each incremental unit of revenue.

It's useful to know because it can tell you what impact a change in the level of your sales has on your profits.

We'd suggest you think about it like this:

Some of your costs vary directly with your sales. For example, the costs of the components to make a product plus your shipping costs to get it to its destination. Or, for a service company, the fees for an expert consultant to produce and deliver a project.

For obvious reasons, these are called 'variable costs'.

And as you'd expect, every time you make and sell another unit of your product or service, these variable costs rise in proportion.

In contrast, you have other costs that don't automatically rise in line with your sales. They're more constant and are known as 'fixed costs'.

They include things like your office rent or the costs to run your finance or HR functions.

They're defined by the fact that producing an extra unit of output in your factory or providing an additional service doesn’t require more of these costs.

If you calculate what's left from your sales after deducting your variable costs, that's your contribution margin — expressed as a percentage of sales.

Contribution margin = 100 x (sales – variable costs) / sales

It assumes that your fixed costs don't change and only your variable costs increase as your sales rise.

Here are some examples of when it can be useful to include contribution margins in your company analysis:

• If you have spare capacity in your business and want to estimate how high your profits could go in the event you were able to fill that unused capacity by winning new customers.

• If you're concerned that demand from your customers may get weaker in the coming months and you want to estimate how large the negative impact on your profits could be.

So in a nutshell, contribution margin can be useful in any kind of scenario analysis or business planning exercise.