Accounting

Contribution
Is, How to Margin:
Calculate What
It, and It
Why You
by Amy Gallo
Need It
October 13, 2017

Ross M. Horowitz/Getty Images

Summary. To understand how profitable a business is, many leaders look at profit
margin, which measures the total amount by which revenue from sales exceeds
costs. But if you want to understand how a specific product contributes to the
company’s profit, you need to look at contribution margin, which is the leftover
revenue when you deduct the variable cost of delivering a product from the cost of
making it. To calculate this figure, you start by looking at a traditional income
statement and recategorizing all costs as fixed or variable. This is not as
straightforward as it sounds, because it’s not always clear which costs fall into
each category. And this is where most managers get tripped up. But going through
this exercise will give you valuable information. Analyzing the contribution margin
helps managers make several types of decisions, from whether to add or subtract a
product line to how to price a product or service to how to structure sales
commissions. But never look at contribution margin in a vacuum. Before making
any major business decision, you should look at other profit measures as well.
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When you run a company, it’s obviously important to understand

how profitable the business is. Many leaders look at profit margin,
which measures the total amount by which revenue from sales
exceeds costs. But if you want to understand how a specific
product contributes to the company’s profit, you need to look at
contribution margin.

To understand more about how contribution margin works, I

talked with Joe Knight, author of HBR Tools: Business Valuation
and cofounder and owner of business-literacy.com, who says “it’s
a common financial analysis tool that’s not very well understood
by managers.”

What Is Contribution Margin?

Knight warns that it’s “a term that can be interpreted and used in
many ways,” but the standard definition is this: When you make a
product or deliver a service and deduct the variable cost of
delivering that product, the leftover revenue is the contribution
margin.

It’s a different way of looking at profit, Knight explains. Think

about how company income statements usually work: You start
with revenue, subtract cost of goods sold (COGS) to get gross
profit, subtract operating expenses to get operating profit, and
then subtract taxes, interest, and everything else to get net profit.
But, Knight explains, if you do the calculation differently, taking
out the variable costs (more on how to do that below), you’d get
the contribution margin. “Contribution margin shows you the
aggregate amount of revenue available after variable costs to
cover fixed expenses and provide profit to the company,” Knight
says. You might think of this as the portion of sales that helps to
offset fixed costs.

How do you calculate it?

It’s a simple calculation:

Contribution margin = revenue − variable costs

For example, if the price of your product is $20 and the unit
variable cost is $4, then the unit contribution margin is $16.

The first step in doing the calculation is to take a traditional

income statement and recategorize all costs as fixed or variable.
This is not as straightforward as it sounds, because it’s not always
clear which costs fall into each category.

As a reminder, fixed costs are business costs that remain the

same, no matter how many of your product or services you
produce — for example, rent and administrative salaries. Variable
costs are those expenses that vary with the quantity of product
you produce, such as direct materials or sales commissions. Some
people assume variable costs are the same as COGS, but they’re
not. (When you subtract COGS from revenue you get gross profit,
which, of course, isn’t the same as contribution margin.) In fact,
COGS includes both variable and fixed costs. Knight points to a
client of his that manufactures automation equipment to make
airbag machines. For this client, factory costs, utility costs,
equipment in production, and labor are all included in COGS, and
all are fixed costs, not variable.

“Some parts of operating expenses, which we assume are fixed,

are in fact variable,” he says. “The costs of running the IT, finance,
and accounting groups are all fixed, but, for example, the sales
force may be compensated with commissions, which would then
be considered variable.”

Doing this calculation right takes “a tremendous amount of work,

and it is critical that you are consistent in your breakdown of fixed
and variable costs over time,” Knight says, but the information
you gain from looking at profitability at the product level is often
worth the effort.

How Do Companies Use It?

Analyzing the contribution margin helps managers make several
types of decisions, from whether to add or subtract a product line
to how to price a product or service to how to structure sales
commissions. The most common use is to compare products and
determine which to keep and which to get rid of. If a product’s
contribution margin is negative, the company is losing money
with each unit it produces, and it should either drop the product
or increase prices. If a product has a positive contribution margin,
it’s probably worth keeping. According to Knight, this is true even
if the product’s “conventionally calculated profit is negative,”
because “if the product has a positive contribution margin, it
contributes to fixed costs and profit.”

“Some companies spend a lot of time figuring out the

contribution margin,” he says. It requires that a managerial
accountant dedicate time to carefully breaking out fixed and
variable costs. For firms like GE, there is a big focus on looking at
products “through a contribution margin lens.” This is important
to the company because GE is “a disciplined firm that works in
very competitive industries and wants to cut out nonproductive
products.” So it prunes the ones that don’t have a high
contribution margin.

It’s likely that a division leader at GE is managing a portfolio of

70-plus products and has to constantly recalculate where to
allocate resources. “As a division head, if I have to cut, I’m going
to cut products that have the lowest contribution margin so that I
can focus resources on growing the business and increasing
profit,” Knight says.

Of course, GE has a lot of resources to dedicate to this analysis.

But it’s not just the GEs of the world that should be considering
this figure, Knight says: “Every company should be looking at
contribution margin. It’s a critical view on profit, in large part
because it forces you to understand your business’s cost
structure.”

What Mistakes Do People Make?

Knight says that there are “so many ways you can make a
mistake,” all of which stem from the fact that “costs don’t fall
neatly into fixed and variable buckets.” He warns that there are
some costs that are “quasi-variable.” For example, you might add
an additional machine to the production process to increase
output temporarily. This falls in between the two categories, since
it could be considered an additional cost due to the higher
production (and therefore variable), or it could be thought of as a
fixed cost since it’s a one-time purchase that doesn’t fluctuate
with the amount of product you’re producing. Sometimes certain
salaries could be looked at this way as well. “The financial analyst
makes a distinction that requires a judgment call on where to
classify these salaries,” Knight says. R&D expenses are also subject
to scrutiny. “They are sometimes considered fixed costs, while
others look at them as direct costs associated with the product.
Your contribution margin could be dramatically different because
of how these costs are categorized.”

Another mistake that some managers make is to assume that you

should cut the lowest-contribution-margin products. But
you shouldn’t use contribution margin­, or any measure of profit,
exclusively; you should consider the fixed cost allocation as well.
Take a company’s cash cows, a term coined by the Boston
Consulting Group to describe products that provide a steady
income or profit. Generally these products require very little
support; you don’t have to invest in sales or do any R&D support.
And yet cash cows generally show up as having a low contribution
margin because they can have high variable costs while not
drawing on the company’s fixed costs. However, you wouldn’t
necessarily want to cut them as a result; “you have to consider the
cost of supporting a product” and “how much of the company’s
fixed costs is associated with the product,” Knight explains.
“When you find that these low-contribution-margin products fill
a product line or are a barrier to entry for a competitor, you
should probably consider keeping the product around.”

Looking at contribution margin in a vacuum is only going to give

you so much information. Before making any major business
decision, you should look at other profit measures as well.

Amy Gallo is a contributing editor at Harvard

Business Review, co-host of the Women at Work
podcast, and the author of the HBR Guide to
Dealing with Conflict. She writes and speaks
about workplace dynamics. Watch her TEDx
talk on conflict and follow her on Twitter.

 @amyegallo