Calculating Contribution Margin | |||||||||||||||||||||
To determine how each of your products are contributing to your net profit, you need to calculate what in business terms is called contribution margin . This is important if you plan to run a profitable business, using these numbers you can decide how to structure your inventory, sales and compensation and expenditures in order to maximize your net profits. The formula for calculating contribution margin is as simple as: contribution margin = sales price – variable cost Now let us take a look at how that will be calculates assuming that you have the following products:
Note here that product B generates the highest total profit, but also has the lowest percentage contribution margin. This means it is the least contributor to your net profit and product C in this case, even though it does not bring in the highest total profit, it is the biggest contributor to tour net profit. How on earth does that happen, it does not make sense, does it?Yes it does, even though product B brings in the highest profits, it is also among items with the highest variable costs, thus in a way that high cost is eating up a chunk of your overall net profit. Information like this does not is not evident on your usual financial statements such as the income statement. This tool however has to be used with other tools to ensure that the right decisions are made with the backing of good financial information. |
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