Unit contribution margin is the difference between the average selling price of a unit of product and the variable cost of making and delivering that unit. This represents the incremental “contribution” of an additional unit of sales towards covering the fixed costs of the business.
Unit contribution margin is generally the easiest and least controversial profit margin to calculate. Variable cost is usually fairly easy to see (upon a visual inspection, following an order through the process) and should contain minimal allocations.
As a general rule, you should avoid allocating variable cost on a percentage of sales basis and seek to map expenses back to physical activities such as ordering, making, picking, and shipping. This can be a challenge for logistics & service businesses that haven’t examined costs closely.
While you can use your financial statements to get started, you should take this opportunity to dig deeper into the business. Direct cost and total variable expense vs. fixed expense is often complicated. The details matter here.
Contribution Margin Isn’t Profit
One key point of contribution margin analysis, particular when you are using it for pricing and product optimization: it’s not the whole story.
Your sales team will point at the contribution margin calculation and ask to take the deal, celebrating the incremental sales volume. More total sales, more gross margin, more operating income. So, what’s not to like here?
It turns out there are three very good reasons to be wary here…
First, you’re setting up trouble for when you need to get more capital. You’re not covering the total fixed cost or ensuring a long term profit for your owners. Repeatedly setting your target profit for a business just above unit variable cost is paving the road towards liquidation. That sales revenue isn’t sustainable unless you start covering fixed expense items and your cost of capital.
Second, be wary of shifts in sales mix or unit economics as the business evolves. If you’re in an multi-product business, look at weighted average contribution margin and pay careful attention to the outliers in your product profitability analytics. Smart accounts have a way of bidding high profit items with competitors and leaving you with low profit dogs. Over time, this will create a problem. Variable cost can also shift with changes in your volume or sales mix, especially if you need to make additional effort to service the business. Large customers have a way of demanding far more of your time than little ones: not only will this increase your total variable expense, it can inundate your leaders with drama that demands “top-to-top” meetings between your companies.
Third, there are many potential constraints on a business driven by unit volume. Your line can only produce a specific amount. Your suppliers can likely only provide a specific amount of materials. Once you exhaust your open capacity, you will need to be able to cover the incremental fixed expense of the business before adding more.
Total variable cost doesn’t get it done. Positive contribution margin is a rationalization. Make sure you’re striving to cover your long term cost of capital. This is especially dangerous in high operating leverage businesses such as heavy manufacturing, where most costs are fixed.
One Good Use: Manufacturing Optimization
While this varies by industry, one good application of unit contribution margin analysis is looking at alternative items on the same line. Most production lines are designed to produce a single generic “item type”. This could be filling a bottle, making a roll of toilet paper, or stamping a metal fitting into a specific shape.
Your engineers can provide you with an estimated rate per hour for your lines. The sum of these outputs, applied to your current product mix, is the upper bound for your sales revenue. What you will likely discover is different products generate different unit contribution margin amounts and thus there is room for optimization.
Same roll of toilet paper. Different selling price, gross profit, and unit variable cost (differences in packaging and materials). Set your pricing and sales strategy to pursue the higher margin items.
By focusing on dollar contribution margin and unit sale amounts rather than margin rate, you can see the true return on operating capacity. Gross profit margin is influenced by selling price. Unit contribution margin shows your value per unit of line time. The line can make 1000 cases of product. It (usually) won’t change that rate for a specific brand or better raw materials. This helps you drive a better sales mix ratio to improve your total contribution.
Be Mindful of Net Sales
Use net sales instead of gross sales. This is a very common error with hasty analysis, since gross selling price is on the invoice (easy to get) and net selling price often involves some digging.
If you are in a business with lots of rebates, commissions, and complicated service models you may discover that part of your high selling price business is actually delivering a very low contribution margin.
Your total contribution margin view on the net income statement is often hiding winners and losers at the account level. Built a contribution margin income statement at the account level using accurate net sales and sales mix to see which customers are truly funding your bonus.
Total revenue and sales dollar figures are vanity. Net income is sanity.