First, a quick review: Your margin is the difference between your revenue and costs. There are many ways to measure margin, including Gross, Net and Contribution. Today we cover Contribution Margins, which is perhaps the most important.
Contribution margins are measures of 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, 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 costs. Most businesses have many products or services each with their own margins. Tomorrow we’ll talk about how to roll all of those up into a single metric for your business.