Company managers put a lot of effort into setting the selling prices of their products and services to maximize profit based on what customers are willing to pay. The contribution margin (sometimes mislabeled as gross margin) tells you how well the products you sell are paying for themselves. According to the Harvard Business Review, the contribution margin formula per unit is:
Contribution margin/unit = selling price/unit - variable costs/unit
A good contribution margin exceeds total costs/unit (i.e. fixed plus variable costs), and you generate a profit margin on each sale.
Rearranging the equation gives you the following formula for the required selling price:
Selling price/unit = contribution margin/unit + variable costs per unit
You can use the contribution margin to set the minimum sales price, which should be high enough to cover your variable costs for producing the product.
Fixed and Variable Costs
Businesses categorize their costs as fixed or variable. Fixed expenses stem from items such as machinery, buildings and other fixed assets, and remain the same whether the asset is sitting idle or is operating at full capacity.
Total variable costs tie directly to the inputs (such as raw materials and labor costs) you acquire through purchase or production, including direct overhead (such as sales commissions and product marketing) – the more inputs you obtain, the higher your variable costs. A product line's or service's total cost is the sum of its fixed and variable costs.
Your ability to make a profit hinges on selling products for a total revenue greater than their total costs. The minimum selling price should cover the specific product's variable costs. Otherwise, you would be losing on each unit produced. The product has gross profit potential if the price is high enough to exceed the fixed and variable production costs (i.e., cost of goods sold).
When you divide contribution margin by net sales, you create a metric called the contribution margin ratio:
If the ratio is positive, the price offsets variable costs and contributes to fixed costs and net profits. The break-even point indicates the price and number of units that just cover the fixed and variable costs. A high contribution margin creates profits.
A negative contribution margin means the product is sold for an amount of revenue less than its variable cost. A very low contribution margin may cause you to lose money on each unit produced.
You can find the contribution margin on a company's contribution margin income statement, where the variable expenses are subtracted from sales to find the contribution margin. If a contribution margin income statement is unavailable, you can use the conventional income statement by adding variable selling and administrative costs to variable production costs, advises the Corporate Finance Institute.
Example of Selling Price Calculation for a Product
In this example, the unit contribution margin for a can of crowder peas equals the net sales revenue per can minus the variable costs (e.g., buying the can and label, buying the peas and other ingredients, assembling the finished product, shipping it to customers, etc.). If the can's variable cost is $1 and the contribution margin is $0.50, the selling price per can would have to be at least $1.50. If the fixed costs were $0.20/can, you would make a profit at a price above $1.70.
Example of Selling Price Calculation for a Service
You can also apply contribution margin to a service-oriented business. For example, suppose you own a car wash where the average price per car wash is $16, and the variable cost per wash is $9. The contribution margin is $7 per wash (i.e., $16 - $9). The contribution margin ratio is $7 divided by $16, or 43.75 percent.
If your supplier raises the price of detergent and polish so that it costs you another $1/wash, your variable costs increase to $10/wash, and each wash's contribution margin decreases to $6 ($16 - $10). Without a price hike, the contribution margin percentage declines to 37.5 percent ($6/$16), cutting into net income.
To maintain the previous contribution margin percentage of 43.75 percent, you must raise the contribution margin/wash to $7.78. The new minimum selling price per wash is the variable cost ($10) plus the contribution margin ($7.78), or $17.78. If a break-even analysis shows you are losing customers due to the higher price so that sales fall below your break-even point, you may need to accept a lower contribution margin. You can respond by lowering prices to increase sales volume and/or cutting variable costs.
This method assumes the company only sells one product, and that the selling price calculated applies to that product. If the company sells multiple products, you need to use a contribution format income statement by item. This allows you to determine the selling price for a specific item.
As you increase the selling price, the contribution margin and net profit also increase. When you decrease the selling price, the contribution margin and net profit also decrease.
Businesses use various formats when they create income statements. These include the traditional income statement, the multiple step income statement, and the contribution format income statement. The contribution format income statement is the only one that lists the variable costs and the contribution margin. The other formats require additional analysis to arrive at these numbers.
Two types of selling prices exist. These include the base selling price and the adjusted selling price. The adjusted selling price reduces the base price by any discounts offered to the customer. Total sales revenue includes sales that occurred at the base price, as well as sales that occurred at an adjusted price. The selling price calculated consists of an average of all selling prices.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.