Calculating the contribution margin – the key to success
Calculating the contribution margin is one of the most important business performance calculations and thus an indicator of the profitability of a business. In this article, you will first find a compact overview of the basics of contribution margin accounting. Afterwards, I will present a variant that you can use to calculate the contribution margin in e-commerce.
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Calculating the contribution margin – cost accounting
In order to make correct entrepreneurial decisions, the assignment of data to events is one of the greatest challenges. What are the causes for success or failure, which product, which activity should be expanded, which should be reduced – these are typical questions of entrepreneurial decisions and income statements. In order to bring light into the darkness, the first task is to set up success and cost figures and to allocate them to each other. This allocation is one of the most important tasks of cost accounting, which is also referred to as internal accounting. Cost accounting picks up internal data and uses it to strengthen the factors that increase operational success and reduce the factors that decrease it.
Calculating the contribution margin – nomen est omen
The understanding of how to calculate the contribution margin increases when one can classify the origin of the term “contribution margin”. The concept of contribution margin provides that a product turnover -or in the language of cost accounting: the turnover of a cost unit- after deduction of clearly attributable costs, contributes to the coverage of the then still uncovered fixed or overhead costs. It is therefore a multi-stage process of allocation and coverage of costs, which pursues the objective of at least covering the costs in the company with the revenues generated. If the revenues exceed the costs, a profit remains as a welcome residual value.
The contribution margin as a KPI
The information provided by the contribution margin that sales revenue covers costs makes the contribution margin an important early indicator of business success: a high contribution margin makes a product or business attractive, while a low contribution margin is likely to curb entrepreneurial euphoria. Every startup and every product launch should therefore have clarity about contribution margins at an early stage to determine whether demand is even capable of financing the costs incurred for a product or service. In online retail, the contribution margin as an important e-commerce KPI determines whether an online store can be operated profitably.
Calculating the contribution margin – it’s very simple
Since the contribution margin is such a central variable in business administration, there are also numerous variants of how to calculate the contribution margin. Which variant to use depends mainly on the size and structure of the company. The more levels there are, which are responsible for success and at the same time cause costs, the more complex the contribution margin calculation becomes.
The single-level contribution margin accounting
However, it is also quite simple: in the single-level contribution margin accounting, the sales revenue of a product is compared with the variable cost of goods sold. Then the contribution margin is:
(1) DB = sales revenue – variable cost of goods sold.
The contribution margin accounting – an example
Variable cost of goods sold are costs that can be directly and unambiguously allocated to a product and are therefore variable. These are typically acquisition costs, which are incurred by traders, or manufacturing costs, which play a major role for producers. An example calculation for a single product shows how easy it is to determine the contribution margin:
(2) Revenue = 10,- Euro, cost of goods sold = 5,- Euro, thus the contribution margin = 5,- Euro.
If the contribution margin per unit is aggregated over all copies sold, the cost contribution margin is obtained for this individual product.
Calculating the contribution margin – multi-level contribution margin accounting
If one starts again from the basic idea of cost accounting, to place profit and cost variables in correlations, it quickly becomes apparent that, in addition to variable prime costs such as acquisition or manufacturing costs, other costs can also be allocated, at least in part. This is attempted in the multi-level contribution margin accounting. The idea here is to obtain a largely complete and realistic profit figure for individual products or activities. In this multi-level contribution margin accounting, too, the complexity of the company is primarily decisive for how many levels there are and which cost variables can be assigned.
Determination of the contribution margin II
As a rule, in addition to the first level of variable cost of goods sold, there is at least one other level to which a portion of the fixed costs can be allocated. These can be, for example, sales fixed costs or development fixed costs. This results in
(3) DB II = DB – fixed sales costs = sales revenue – variable cost of goods sold – fixed sales costs
Fixed sales costs are those costs that are explicitly incurred by the sale of a single product. In multi-level contribution margin accounting, however, other fixed costs – such as those of development, controlling or management – can also be allocated, provided that the connection between product and costs is evident in the sense of the causation principle. The greater the proportion of costs to be allocated to individual products, the more the company can be organized decentrally and according to the polluter-pays principle: where revenues are generated, costs can and must also be incurred, but only to such an extent that the costs are covered overall. This is the idea behind contribution margin accounting.
Calculating the contribution margin – the e-commerce code
The development of e-commerce has brought about a substantial change in contribution margin accounting. Whereas in the age of classic mass media, marketing and advertising could only be allocated to a limited extent and were often considered part of fixed costs, the sale of goods on the Internet significantly increases the transparency of marketing costs incurred. With the help of WebAnalytics data, it is possible to determine quite precisely which factors in online marketing determine the success of a product. I call this special contribution margin calculation the e-commerce code, because it summarizes the relevant success and cost variables in a focused manner. These are
- Impressions I
- Click-through rate CTR
- Conversion rate CR
- Shopping cart WK – corresponds to the sales revenue in e-commerce
- variable cost of sales vSK
- Cost per Click CPC.
Calculation of e-commerce success with the help of DB II
With these quantities, the contribution margin after variable cost of goods sold and online marketing costs CPC can now be depicted:
(4) DB = I x CTR x CR x (WK – vSK) – I x CTR x CPC.
Here, I x CTR stands for the number of Internet users who visit the online store. A subset of these – I x CTR x CR – also buys one or more products. The conversion rate CR reflects the proportion of page visitors who also complete a purchase online.
So while only some of the site visitors generate a contribution margin, all visitors incur online marketing costs. These are calculated by multiplying the number of visitors by the click or contact price CPC.
DB II – an example
A practical example shows the relationship:
(5) DB = 10,000 x 0.05 x 0.02 x (80 € – 45 €) – 10,000 x 0.05 x 0.5 €
(6) DB = 350 € – 250 € = 100 €.
The resulting ratio of contribution margin I and online marketing expense of 250/350 or 71% is typical for the online channel, where intense competition leads to great pressure on contribution margins and thus on costs.
Calculating the contribution margin – the contribution margin as a measure of success
The cost accounting of a company can – in contrast to the external accounting, which includes bookkeeping and balancing – be designed individually and should support decisions and objectify decision facts. This also applies to contribution margin accounting, which is very flexible on the one hand due to the wide range of design options, but on the other hand is also sensitive with regard to overly individual designs. In this respect, contribution margin accounting also reflects the corporate and controlling culture to a certain extent, which can either proceed in a very detailed and decentralized manner or in a more generalized and thus more centralized manner.
The contribution margin as a performance indicator
This background must be taken into account when considering the contribution margin as a performance indicator. If all attributable cost variables are actually allocated and deducted within the framework of contribution margin accounting, then the contribution margin is a useful performance indicator at the level of the cost or service providers in the company. If, on the other hand, this is not done, the contribution margin should be viewed with caution, as it is latently too high.
Data Driven Marketing and E-commerce
The data-driven marketing that characterizes e-commerce makes it possible to allocate costs in detail, not only in marketing but also at other levels of service provision. Accordingly, typical e-commerce companies have only a small proportion of fixed administrative costs that can no longer be allocated. In this case, the contribution margin is a greatly shrunk, if you will, unsparing residual figure, which at the same time increases the incentive to further reduce the costs of service provision through growth and economies of scale.
Operating profit and contribution margin
The aggregation of contribution margins can also be used to derive a performance indicator. The sum of the contribution margins of all cost units – i.e. service areas or products – is the operating result in multi-level contribution margin accounting. Subsequently, only the financing costs and depreciation are subtracted from the operating result in order to arrive at the annual profit or loss.
Author and photo: Dr. Dominik Große Holtforth
Literature: Dietmar Vahs/Jah Schäfer-Kunz: Einführung in die Betriebswirtschaftslehre, 5th ed. 2007, p. 680 ff.