Running a shift-based business is a constant juggle, and it’s hard to know what’s working and what isn’t when you’re busy with daily operations. Luckily, there’s an important tool to help you identify what is actually profitable in your business — contribution margin.
It sounds like technical jargon that your accountant might throw at you, but it’s quite simple to measure and understand. We’ll give you a basic breakdown of how to calculate contribution margins and how to use them to grow your business.
Contribution margins made simple
A contribution margin is the difference between revenue made by selling a product or service and the costs to create the product or service. What’s left goes toward fixed expenses, and if there is any money left over, the business makes a profit.
The formula to figure it out is:
Revenue - Variable costs = Contribution margin
Revenue: Money made from the sales of products or services.
Fixed costs: Costs that stay the same (such as insurance, rent, and property taxes), no matter the number of products produced.
Variable costs: Expenses that change according to the number of a product that is produced — for example, materials or sales commissions.
Contribution margin ratio: A ratio showing the contribution margin in terms of a percentage of the price. It’s defined as contribution margin divided by revenue. A higher CMR means a more profitable product or service.
Why should businesses care about contribution margins?
Contribution margins show whether your company can cover costs with current revenue. When analyzing different products across your business, understanding contribution margins enables important operational decisions. This can lead to improving the profitability of product lines by investing more in your high-performing items and discontinuing those that are low-performing.
Do “good” contribution margins vary by industry?
Absolutely! What is a good contribution margin, anyway? The closer the contribution margin is to 100%, the better, but expenses vary from industry to industry, so a “good” contribution margin can look very different depending on the business.
If you’re concerned you don’t have good contribution margins, see what is considered good within your industry and current market conditions before you start panicking.
Working example: Contribution margins in a café
To explore this further, let’s use an example of your local cafe trying to measure the contribution margin of a cup of coffee for March.
The revenue is the sales made from all coffees sold in March, which is $10,000.
Variable costs include items such as coffee beans, water, milk, disposable cups, and labor costs, which total $4,000.
In this example, the contribution margin is $10,000 - $4,000 = $6,000. The contribution margin ratio shows a margin of 60% ($6,000/$10,000).
That sounds like a good result. But this same café also sells muffins.
The revenue from all muffins sold in March is $6,000. Variable costs total $1,000. The contribution margin is $6,000 - $1,000 = $5,000. The contribution margin ratio shows a margin of 83% ($5,000/$6,000).
This café owner has a higher contribution margin from selling coffee, but the muffin sales are much more profitable (83% vs 60%). Both product lines are delivering value for the café with relatively high margins, but higher profits could be achieved if the café focused on selling a higher number of muffins.
Constraints of contribution margin analysis
There are a couple of limitations to creating a contribution margin analysis — the first being the time it takes to create. Gathering all the required information, organizing it, and then doing the math takes time.
If you are on your own or working with a small team, this time can significantly take away from business operations.
The second constraint is that the contribution margin analysis format may not be flexible enough to handle shift-based businesses. Due to the number of ever-changing factors and individual products and services, it may be too difficult to get a proper reading on operational costs. Not to mention when there are outside factors that affect a business’s costs, such as supply chain issues or economic health.
How to improve your business’s contribution margins
To improve the contribution margin, a business has a range of options that include:
Price increases: A price change is an easy way to improve the margin, but the business needs to evaluate whether the customer is willing to pay more for the product.
Operational efficiencies:Operational efficiencies require a real focus on understanding all of the elements that go into producing the product and how to make improvements. This could be through technology, increasing capacity, or purchasing more productive equipment.
Reducing costs: Reducing costs can be the most difficult option, as it will likely mean labor reduction or negotiating to spend less with your suppliers.
Negotiating supplier discounts: If you purchase a lot of goods or have a positive relationship with your suppliers, ask if they can offer any discounts.
Increase customer retention: Existing customers already like your business. Focus on keeping them, since gaining new customers carries additional costs. You can earn more money by encouraging loyalty and increasing existing customer sales.
Profitability starts here
Understanding contribution margin is an important element of evaluating the profitability of the products in your business. Whether you employ the services of a professional accountant or use an online calculator to work out your company’s contribution margin ratio, you must have the right information.
Deputy can monitor your labor costs and integrate with other programs that let you track sales and supply costs. This is actually why Masala Wok chose Deputy!
