Contribution margin explains how a particular product or service contributes to a company’s profit. Contribution margin is the remaining revenue left over after subtracting the variable cost of offering the product (Contribution Margin equals Price or Revenue per unit minus Variable Cost per unit). This measure is important for businesses to make strategic decisions about adding more profitable or removing less profitable product lines and how to accurately set prices for a product (Gallo, 2017).
Variable costs are expenses that vary as fluctuating quantities of units are produced. This may be the raw materials necessary to produce more units or it may be the commissions that are paid to salespeople as they sell more or fewer goods. A negative contribution margin means each unit produced is losing money for the company. To resolve this, companies must raise the price or drop the product. A positive contribution margin shows that each unit is profitable and should continue to be promoted as this contributes to fixed costs and profit.
Another way to accurately set a price for a product is to run a Breakeven Analysis. This calculation determines how many units must be sold at a particular price to cover the fixed costs—or break even (Breakeven equals fixed costs divided by contribution margin). Setting the correct price for a service or product may be even more profitable than boosting sales volume (Gallo, 2014).
Fixed costs are constant and remain the same regardless of the quantity of units produced. Fixed costs include things like rent, salaries, and promotional materials. Once the contribution margin for a product is determined, it is divided into the fixed costs to find the breakeven number of units that need to be produced before making a profit. If a company sells fewer units than the Breakeven, they are losing money. Any units sold above the breakeven is profit. The goal is to sell as many units as possible above the breakeven number of units.
When used together, Contribution Margin and Breakeven Analysis are marketing tools that offer powerful insights that help marketers set accurate prices and determine which products drive a company’s profitability (Kotler, et al., 2017).