Learn how contribution margin helps you make better pricing decisions, evaluate product profitability, and determine your break-even point.
Contribution margin is the amount remaining from sales revenue after deducting variable costs. It represents what's available to cover fixed costs and generate profit. The formula is: Sales Price - Variable Costs = Contribution Margin.
Contribution margin is one of the most important metrics for understanding your business's profitability at a product or service level. Unlike gross margin, which includes some fixed overhead costs, contribution margin focuses purely on the relationship between price and variable costs.
The portion of sales revenue that exceeds variable costs and contributes to covering fixed costs and generating profit. It can be expressed as a dollar amount per unit or as a percentage of sales (contribution margin ratio).
Understanding your contribution margin helps you:
A healthy contribution margin for most businesses is between 40-60%. Below 30% makes it difficult to cover fixed costs, while above 70% may indicate pricing power or low competition.
Contribution margin is one of the 10 essential financial KPIs every business should track alongside metrics like cash flow, profit margins, and customer acquisition costs.
Contribution Margin = Selling Price per Unit - Variable Cost per Unit
Example: If you sell a product for $100 and your variable costs are $40, your contribution margin is $60 per unit.
Contribution Margin Ratio = (Selling Price - Variable Costs) / Selling Price
Example: Using the same numbers: ($100 - $40) / $100 = 60%
This means 60 cents of every dollar in sales is available to cover fixed costs and profit.
Your contribution margin sets the absolute floor for pricing. Never price below your variable cost—every sale at that price loses money. But knowing your contribution margin also helps you:
When you have limited capacity (production time, shelf space, sales bandwidth), contribution margin per unit helps you prioritize:
Focus on products with the highest contribution margin per unit of constrained resource (e.g., per production hour, per square foot of shelf space).
Contribution margin is essential for calculating your break-even point:
Break-Even Units = Fixed Costs / Contribution Margin per Unit
Break-Even Revenue = Fixed Costs / Contribution Margin Ratio
Example: With $50,000 in monthly fixed costs and a $60 contribution margin per unit:
Don't confuse contribution margin with gross margin. Gross margin includes allocated fixed manufacturing overhead, while contribution margin only considers truly variable costs that change with each unit sold.
The biggest mistake is including fixed costs in your variable cost calculation. Remember:
Variable costs per unit may decrease at higher volumes due to:
Factor these into your analysis when projecting growth scenarios.
Understanding contribution margin is foundational to financial decision-making. Use this metric to:
Understanding your margins is also crucial for effective cash flow forecasting, as it directly impacts how quickly revenue converts to available cash.
Need help analyzing your contribution margins or building a comprehensive profitability model? Our team of CPA professionals can help you understand your numbers and make better financial decisions.