Contribution Margin: Are you leveraging this profit trigger?
Do you realize the role variable costs play in your operation?
By S. Lakshmi Narasimhan Founder, Ignite Insight LLC | May 24, 2015
Owners adore continuous profits. Management too adores them; it is only that they have to deliver them. That is not easy. Even when revenues are riding high, often, retaining profits out of incremental revenues is a completely different ball game. Enter the all season all reason elixir - contribution margin.
Understanding how your costs behave in the operation is critical to optimizing contribution margin. It may well provide you that elixir that will make your business your owner's favorite.
Contribution Margin Defined
What is Contribution Margin? Contribution Margin is simply Revenues minus (-) Variable Costs.
Contribution Margin is based on the principle of the extent of contribution a revenue item makes to the total profit. It recognizes that to earn revenues, both fixed and variable costs will be incurred. However, a change in revenue or sales quantity will only affect the variable costs. Fixed costs remain unchanged irrespective of sales or revenue quantities.
So contribution margin takes into account only those costs, which move with business volume - variable costs. Its premise is that by deducting variable costs from revenues, you get an indication of what the bottom line is which is relevant to business volume. This is also the reason why fixed costs do not feature in the contribution margin calculation.