“Some parts of operating expenses, which we assume are fixed, are in fact variable,” he says.
For this client, factory costs, utility costs, equipment in production, and labor are all included in COGS, and all are fixed costs, not variable. Knight points to a client of his that manufactures automation equipment to make airbag machines. (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. Some people assume variable costs are the same as COGS, but they’re not. Variable costs are those expenses that vary with the quantity of product you produce, such as direct materials or sales commissions. This is not as straightforward as it sounds, because it’s not always clear which costs fall into each category.Īs 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. The first step in doing the calculation is to take a traditional income statement and recategorize all costs as fixed or variable. How do you calculate it?Ĭontribution margin = revenue − variable costsįor example, if the price of your product is $20 and the unit variable cost is $4, then the unit contribution margin is $16. You might think of this as the portion of sales that helps to offset fixed costs. “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.
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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. 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. It’s a different way of looking at profit, Knight explains. 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. To understand more about how contribution margin works, I talked with Joe Knight, author of HBR Tools: Business Valuation and cofounder and owner of, who says “it’s a common financial analysis tool that’s not very well understood by managers.” What Is Contribution Margin? But if you want to understand how a specific product contributes to the company’s profit, you need to look at contribution margin. Many leaders look at profit margin, which measures the total amount by which revenue from sales exceeds costs. When you run a company, it’s obviously important to understand how profitable the business is. Before making any major business decision, you should look at other profit measures as well. But never look at contribution margin in a vacuum. 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 going through this exercise will give you valuable information. And this is where most managers get tripped up.
This is not as straightforward as it sounds, because it’s not always clear which costs fall into each category. To calculate this figure, you start by looking at a traditional income statement and recategorizing all costs as fixed or variable. 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 understand how profitable a business is, many leaders look at profit margin, which measures the total amount by which revenue from sales exceeds costs.
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