Unit Economics: What is a Contribution Margin?
What is a Contribution Margin?
“Unit Economics” is a term that generally refers to examining the profit and loss associated with each product your company sells. Most discussions of unit economics focus on a specific metric called the contribution margin.
Contribution margin is a measure of your per unit profit, by subtracting the variable cost per unit from the sale price of the product or service. It is very similar to the Net Margin (See Gross vs Net Margins), but is calculated at the individual sale level which makes it more difficult to determine. For example, if you sell basketballs for $25 each and it costs you $10 to make each ball, your contribution margin per basketball is $15 or 60%.
The benefit of tracking your contribution margin is that you can easily do a break-even analysis, which shows how many units you need to sell to break even on your costs. For example, if your annual fixed costs (office space, administration, etc.) are $100k and the contribution margin for each item you sell is $5, you break even when you sell 20,000 units a year.
Contribution margin is most often used for businesses that sell physical goods, since it can help take into account returns and defects, which other metrics may exclude. It can be hard to determine the contribution margin for subscription businesses since the sale is not a single transaction, but you can estimate it if you know how long customers maintain their subscriptions on average.
Of course, very few businesses have a single product with a single price and a fixed cost. Most businesses have many products or services each with their own margins.
Tomorrow we’ll discuss a variety of different businesses and how you can calculate their unit economics (contribution margin).