The contribution margin is one of the most important numbers in your business, and one that you should always take into account when making any type of product-related decisions.
So, if you don’t know what a contribution margin analysis is, how you calculate the contribution margin per unit, or why it’s so important, keep reading to find out.
Throughout the post, we’ll be using the example of a bakery (the same one you may already know from the post about the cost structure).
In case you haven’t read that one, one of the bakery’s employees is a baker; he bakes everything there: bread, pastries, pies, cakes… everything.
But the bakery also has a specialized cake decorator, whose only job consists of decorating wedding cakes.
So, as we saw in the post about the cost structure, if the costs change as the number of units produced changes, we call them variable costs. Otherwise, we say they are fixed costs.
And, if costs can be easily linked to the cost object we are analyzing we say they are direct costs, while if they need to be allocated, we say they’re indirect.
If you want more details on this, I suggest you read the post about the cost structure.
In the case of the wedding cakes’ production line, examples of direct variable costs would be the ingredients used to manufacture the cakes, or the package used to deliver them in.
An example of direct fixed cost, would be the cost of the cake decorator that works on the wedding cakes, and on nothing else.
Examples of indirect variable costs, could be the electricity required to keep the ovens working, or the water required to wash the utensils used to make each cake.
Lastly, indirect fixed costs, could be the rent of the bakery, and the salaries of the employees that are shared with other cakes and breads’ production lines.
How to calculate the contribution margin per unit
To calculate the contribution margin, we only care about variable costs.
In fact, the contribution margin formula is equal to selling price, minus variable costs per unit.
What is the contribution margin per unit formula?
Contribution margin per unit | = | selling price per unit | - | variable costs per unit |
But why only consider variable costs? After all, we have to cover both variable AND fixed costs, right?
Well, we want to use the contribution margin to make decisions for the future. So, we will be working with estimates. And while variable costs per unit do not change much depending on how many units we produce, fixed costs do change a lot, or may change a lot. And since we are working with estimates, and we have to predict how many units we will produce, our estimation of the fixed costs per unit may be off by a lot.
So, working with fixed costs per unit can be very problematic because of the big uncertainty regarding the number. And that’s why we want to work with the contribution margin, which by taking the fixed costs per unit out of our analysis, eliminates a potentially huge source of error.
Anyway, let’s get back to wedding cakes production line, and see how to calculate the contribution margin per unit.
Let’s assume we are selling each cake for $100, and our variable costs are $15 for direct costs, and $5 for indirect.
This means that if we subtract these costs to the selling price, we get to a margin of $80 per cake. And that’s our contribution margin per unit.
One note on implementing this in practice though: while in theory these cost calculations seem very simple to do, in practice, getting to these $5 may not be so easy (after all, how easy would it be to calculate how much electricity, water, and other indirect variable things we are spending per cake?).
One important thing to note here, is that although we could perfectly calculate our contribution margin per unit for the past, the one that’s really interesting to make decisions for the future, is the future one. So, we are trying to calculate future costs. And we will never be able to perfectly nail those down. So, our contribution margin will never be exactly right. And we have to be comfortable with that.
We have to work with estimates, and rough numbers, focus on things that are material to our variable cost per unit, and be ok with knowing that we will always have some degree of error, and the important thing to know is on which side we can be making that error, so that we don’t end up making decisions based on a completely stupid number.
Contribution margin meaning
But anyway, let’s go back to our bakery and see what those $80 per cake mean.
The $80 contribution margin means that whenever we sell a cake we get a margin of $80 that contributes to cover our fixed costs (hence the name contribution margin).
This allows us to calculate how many units we would need to sell to cover all our costs (also known as the break-even point).
And, once our fixed costs are covered, the $80 contribution margin per unit tells us by how much our profit would grow with each cake we sell (before taxes, of course).
What is the contribution margin per unit? The contribution margin per unit is equal to unit price minus variable cost per unit. It tells us how much money each unit we sell contributes to cover our fixed costs, and after fixed costs are covered, by how much our profit grows with the sale of each unit.
In our example, we have seen that the bakery has a specialized wedding cake decorator that costs $1,500 per month, which is a direct cost of producing wedding cakes. Obviously, the wedding cakes’ production line should generate enough margin to cover this cost.
But the wedding cake production unit also needs to cover its share of the bakery’s indirect fixed costs, which in our example, amounts to $2,000.
An important thing to note here, is that those $2,000 are the part of the overall business fixed costs that we considered that should be covered by the wedding cakes’ production line.
And it’s extremely important to realize that this is WHAT WE "CONSIDER" THAT SHOULD BE COVERED by the wedding cakes’ production line. Because deciding which part of the overall fixed costs should be covered by each business unit is a judgement call. And that’s one more reason why it’s good to work with a contribution margin, which isn’t affected by this decision.
Anyway, summing up, the wedding cakes’ total contribution margin must be enough to cover the $1,500 in costs that we have because we make them, and $2,000 of the overall fixed costs, that we decided that should be covered by the wedding cakes’ production.
This means that we want our wedding cake business to cover a total of $3,500 of fixed costs per month.
Since the contribution margin per each wedding cake is $80, when we divide the $3,500 by the $80, we come to the conclusion that we would need to sell 43.75 cakes every month for $100, just to cover all our costs; that is, to break-even (well, actually 44, since we can’t sell wedding cakes by the piece).
And this is why the contribution margin is such an important number to know.
Why it's important to know the contribution margin per unit
Would selling 44 cakes for $100 each, seem like a reasonable thing to do? Or do we need to take action to improve this minimum sales threshold, such as raise our prices or cut our costs?
Because if selling these 44 per month isn’t a reasonable expectation, this business may have a huge problem.
In this case, we would have to make a further analysis to understand if the $2,000 of fixed costs allocation is a fair one. And if we find that it is, then this business really has a big, big problem.
And this is one of those issues that can be easily caught by doing a simple contribution margin analysis. And, a reason why I consider it to be so important for anyone that’s running any business.
Anyway, this covers all the basics regarding the contribution margin per unit analysis. I hope you found it useful!