Why Contribution Margin is crucial for your business?

Knowing contribution margin of your products and customers is key when you run your business and make day to day decisions on pricing, order magnitude, promotions, bundles, and borrowing.

Contribution margin is a crucial financial metric for businesses as it provides valuable insights into the profitability of individual products or services. It is calculated by subtracting variable costs from revenue and represents the portion of sales revenue that contributes to covering fixed costs and generating profit. Here are several reasons why contribution margin is important for businesses. Below are some the most important ones:

Finance professional calculating contribution margin

Profitability Analysis:

Contribution margin helps businesses analyze the profitability of each product, service or client independently. By understanding the contribution margin for different offerings, companies can focus on investing, promoting and optimizing the most profitable ones.

Cost / Volume / Profit Analysis:

Contribution margin is an integral part of cost-volume-profit (CVP) analysis. It helps businesses understand the impact of changes in sales volume on profitability; in plain English, you can understand the magnitude of price changes on your bottom line. This analysis is essential for making informed decisions about pricing, production levels, and overall business strategy. As an example, if you are lowering the price of a product by 10% or give 10% discount to a client, you may reduce your profits by over 50% without realizing the impact on your overall profitability. Or if you order too much, your inventory carrying cost may increase greater than the volume discount you receive from a vendor and decrease your overall profitability.

Breakeven Point:

The contribution margin is used to calculate the break-even point, which is the level of sales at which total revenues equal total costs. Knowing the break-even point is crucial for business planning and risk assessment. As an example, if you need to use borrowed cash to buy extra inventory, the contribution margin analysis will help you decide if it is worth paying for the interest for the cash borrowed.

Day to Day Business Decision Making:

Businesses use contribution margin to make decisions about resource allocation, product pricing, and resource utilization. It assists in identifying the most profitable products or services and can guide decisions on whether to discontinue less profitable offerings. This is why you see financial planning and analysis departments become the best friends of manufacturing / operations teams when SKU rationalization is the discussion topic with the sales and marketing teams :)

Margin of Safety:

Contribution margin is also a key factor in determining the margin of safety, which represents the difference between actual or expected sales and the break-even point. A higher margin of safety provides a buffer against unexpected changes in sales or costs. Companies tend to offer higher promotions to the higher contribution margin items or bundle them with complimentary products which has lower contribution margins. Here is another example; for a new client one-time discount can be offered. If this company can calculate the overall profitability of that particular client based on the products they choose to buy, this company can make informed decisions on the current and estimated future profitability.

Cost Control:

Understanding contribution margin allows businesses to focus on controlling variable costs. By managing variable costs effectively, companies can improve their overall contribution margin and profitability. As an example, when your material or marketing costs increase as a result of macro-economic factors, you can decide on how much profitability is enough to run the business before raising prices. If you can delay the price increases for a while, you may gain market share as some of your competitors may not have enough room to bear the higher costs and raise prices sooner.

Performance Evaluation:

Contribution margin analysis can be used to evaluate the performance of different business segments, departments, clients, sales channels or product lines. It helps identify areas of strength and weakness, allowing for targeted improvements. If you have a client with higher manufacturing and supply chain costs, you can compare this client with a more profitable one and see what you can change to improve your profitability. It can be offering similar products that have higher margins (training customers / directing them to profitable products), switching to a cost-effective carrier or asking customers to order sooner to meet their delivery deadlines.

Strategic Pricing:

Contribution margin is instrumental in setting optimal pricing strategies. Businesses can use it to strike a balance between generating revenue and covering variable and fixed costs, ensuring sustainable profitability. Particularly in healthcare and other contract businesses, contribution margin analysis will help companies gain more sole source contracts; sometimes it is okay to lower the price to please clients, secure large contracts and improve overall profits. This may not always be possible but if it is, companies should focus on maximizing the total amount of cash / profits not just the percentages.

In summary, contribution margin provides a comprehensive view of the financial health and profitability of a business. It aids in strategic decision-making, cost management, and overall performance evaluation, making it a vital metric for businesses aiming to achieve long-term success. I strongly advise any company to work with professionals who are experts in financial and business analysis, in addition to accounting and financial reporting. A Fractional CFO can be the glue between sales, marketing, operations departments and accounting to develop and execute strategies to improve the overall revenue, profitability and cash flow.