Have you ever wondered why revenue is increasing but the bottom line seems to remain the same? It could be your contribution margin — the amount of revenue that remains after variable costs are deducted. When it comes to growing businesses, tracking figures like gross sales and net profit aren't always enough.

Understanding contribution margin can lead to more strategic pricing decisions and increased revenue when preparing to scale. Not sure which products are successes and which are failures? Analyzing the contribution margin can help with that too.

Keep reading to learn more about contribution margin, including what it is, how to calculate it, and how to use it to make informed business decisions.

Table of Contents

• What is contribution margin?
• Why contribution margin matters for mid-sized businesses
• Contribution margin vs. gross margin
• Fixed costs vs. variable costs
• What the contribution margin says about your business
• Analyzing contribution margin
• Contribution margin case study
• Strategies for improving contribution margin
• Using QuickBooks for contribution margin analysis
• FAQ

What is contribution margin?

Contribution margin is the amount of money left after subtracting variable costs from the selling price of a product. The contribution margin is calculated as revenue minus variable costs.

Contribution margin = Revenue - Variable costs

This can also be analyzed on a per-unit basis, in which case the formula is:

Contribution margin per unit = Selling price per unit - Variable costs per unit

But contribution margins aren't just for analyzing products. This key metric can be used to analyze services as well. The contribution margin tells businesses how much money is left to scale or grow.

Let's say a mid-sized landscaping business charges $1,000 for a project with variable costs of $600 for materials and labour. The contribution margin equals $400 ($1,000 - $600).

This tells us there is $400 left to cover fixed costs. Once fixed costs are paid, any remaining money can be used to invest in the business.

Contribution margins can also be expressed as ratios or percentages by dividing the resulting dollar amount by total sales. In this case, you can use the following formula:

Contribution margin ratio = (Total sales - Total variable costs) / Sales

Plugging in the numbers from the above example results in a ratio of .4.

Contribution margin ratio = ($1,000 - $600) / $1,000 = .4

This can also be expressed as 40% by multiplying the result by 100. This tells us the contribution margin is 40% of sales, which also means that 40% of sales revenue is being used to pay for variable costs.

Why contribution margin matters for mid-sized businesses

For businesses looking to expand, understanding contribution margins can help assess the profitability of new products and services. This metric can also shed light on how existing products and services compare — so management can determine which are the most profitable and which need to be improved or even dropped.

Calculating contribution margins can help CFOs and finance teams make informed decisions regarding scalability, pricing, and discounts. In uncertain markets where costs are skyrocketing, businesses will notice their contribution margins shrinking. They can then do further analysis to determine how to get back on track to reach their profitability goals.

Contribution margin vs. gross margin

Contribution margin should not be confused with gross margin. Both are useful in assessing profitability, but they include different components of the income statement and serve different purposes. The contribution margin is commonly used by management for decision-making, while the gross margin is often calculated as part of the accounting and reporting process.

Let's take a look at the two formulas and what they are often used for.

Contribution margin formula

The contribution margin focuses on variable costs. Remember, the contribution margin formula is:

Contribution margin = Selling price - Variable costs

This helps identify if there is enough money from sales after variable costs are deducted to cover fixed expenses.

If a product sells for $200 and the variable costs are $120, the contribution margin = $200 - $120 = $80. This works out to 40% of sales: ($80/$200) x 100. So there's 40% of sales remaining to cover fixed costs. This is useful for comparing product lines and determining which are the most and least profitable.

Gross margin formula

The gross margin formula is used in product-based businesses and takes into account costs of goods sold (COGS), which includes fixed production costs.

The formula used to calculate gross margin is:

Gross margin = Revenue - COGS

Like the contribution margin, the gross margin can be shown as a ratio or percentage by dividing by total revenue.

Gross margin ratio = (Revenue - COGS) / Revenue

Multiply this by 100 to get a percentage of revenue.

The same product that sells for $200 has COGS of $140, which includes the variable costs of $120 plus fixed costs of $20.

Gross margin = $200 - $140 = $60.

When we convert this to a percentage, we get 30%: ($60/$200) x 100.

Because the gross margin factors in fixed costs as well as variable costs, there is less money from sales left as profit — 30% versus 40% when only considering variable costs, as in the contribution margin.

Fixed costs vs. variable costs

Fixed costs are generally more difficult to adjust than variable costs, so it's helpful to consider the contribution margin in addition to the gross profit margin. One key to understanding profit analysis is learning the difference between fixed costs and variable costs.

If these costs are confused, profit analysis based on the costs will be incorrect.

Fixed costs

Fixed costs are the expenses that don't vary with production volume. Examples include rent, salaried staff, equipment leases, utilities, and insurance. These types of expenses are generally stable over time.

Variable costs

On the other hand, variable costs fluctuate with production. The more units are produced, the more variable costs will be. These expenses include things like materials, hourly wages, shipping, and sales commissions. Because these costs aren't stable over time like fixed costs, variable costs can be adjusted faster than fixed costs. 

What the contribution margin says about your business

Determining how to interpret the contribution margin and where to go from there comes down to whether the number is high or low. But what is considered high or low? It can help to go by industry standards (sometimes found on the Statistics Canada site), or you can use competitors' data if it's available.

• A higher contribution margin means there is more cash available for paying fixed costs or scaling the business. A business may struggle financially if it can't find a way to increase sales when it has a low contribution margin.
• Keeping an eye on the contribution margin over time tells CFOs whether business efficiency is improving or there are increasing cost pressures. 

Analyzing contribution margin

There are a number of different ways to analyze the contribution margin. Here are a few to consider, depending on the industry and type of business.

Contribution margin:

• By product or service line
• By customer type or region
• By trends across months or quarters

Pro tip: Software solutions like QuickBooks Advanced make this easy by including dashboard tools that track contribution margin by business segment.

Break-even point

An important way to use the contribution margin is as part of calculating the break-even point. The break-even point is when total costs are equal to total revenue. At this point, the business is earning zero dollars. Below this point, the business will be operating at a loss. Therefore, you can calculate the break-even point using this formula:

Break-even point = Fixed costs / Contribution margin ratio

Since the contribution margin shows how much money from each sale is available to cover fixed costs, it also tells us how much we need to sell to break even.

Example: Break-even analysis using contribution margin

A beverage company in British Columbia has fixed costs of $20,000 each month. The contribution margin per beverage sold is $50. How many beverages do they need to sell each month to break even?

Break-even = Fixed costs / Contribution margin per unit = $20,000/$50 = 400 beverages

In order to pay their overhead every month, the beverage company must sell 400 beverages per month. Beverages sold over the 400 mark will go straight to profit. 

Contribution margin case study

A mid-sized landscaping company has locations in Toronto, Ottawa, and Hamilton. They employ 60 staff including landscapers, designers, sales reps, and regional managers.

Their services include two core offerings:

• Lawn care (weekly maintenance, fertilization, and weed control)
• Hardscaping projects (patios, retaining walls, and outdoor kitchens)

The CFO is tasked with determining if these services support growth and whether the company should offer bundle pricing.

Here's the data available for their analysis:

Lawn care

• Average sale = $150
• Variable costs = $100, which includes fuel, hourly labour, and materials
• Contribution margin = $150 - $100 = $50
• Contribution margin ratio = $50/$150 = 33%
• Volume = 2,000 jobs per month across all locations

Hardscaping projects

• Average sale = $6,000
• Variable costs = $3,000, which includes materials, subcontractors, and permits
• Contribution margin = $6,000 - $3,000 = $3,000
• Contribution margin ratio = $3,000/$6,000 = 50%
• Volume = 80 projects per month across all locations

When looking at the data, the CFO sees that hardscaping projects bring in more revenue per month and have a higher contribution margin ratio even though there are fewer jobs per month (50% vs 33%).

Because of the lower contribution margin on lawn care, the landscaping company is relying on higher volume for this service to be profitable.

Based on the data available for these two offerings, the company can make high margin offerings a priority while keeping an eye on the volume of lawn care packages sold to make sure this service doesn't become unprofitable.

To promote the growth of the business, the company could consider a new offering that bundles the two services at a slight discount to entice new customers (or lawn care package customers) that have been considering a hardscaping project.

Strategies for improving contribution margin

The components of the contribution margin formula (selling price and variable costs) can be adjusted to improve the contribution margin. Reducing costs and increasing prices will both impact the contribution margin in a positive way.

Here are some ways to do that:

• To reduce costs, buy in bulk to get discounts, negotiate for lower supplier rates, or re-evaluate packaging and logistics for lower costs.
• Increase prices by adding value to justify a price increase or use pricing tiers for service bundles.

Other ways to impact sales and reduce costs include promoting products and services that have a higher margin and reducing labour-intensive tasks in favour of automated ones. 

Using QuickBooks for contribution margin analysis

QuickBooks Online Advanced provides valuable tools for CFOs and finance team leads to help turn data into insights. Features like permission roles allow for team-based reporting, and forecasting tools can help track contribution margin changes. Class tracking allows comparisons of service lines, and custom reports can monitor variable and fixed costs.

Ready to turn your financial data into actionable insights and boost your contribution margin? Discover how QuickBooks Online Advanced can empower your financial team for strategic growth.