GlossaryKind of term: Cost and economicsContribution margin
What is contribution margin?
The contribution margin is an order's revenue less its variable costs: what the order contributes towards your fixed costs and your profit.
You can work it out per part, per order or per period. Variable costs change with output: material, subcontracted operations, tool wear, energy, packaging and freight. Fixed costs run on even when nothing is made: depreciation, rent, permanent staff, office costs. The sum of all contributions pays for the fixed costs; whatever is left after that is profit. Expressed as a share of revenue it is called the contribution margin ratio.
What does contribution margin depend on?
Which costs are variable depends on the time frame and on the business. Pay for permanent staff runs on in a quiet week and is fixed in the short term; overtime and agency staff brought in only for an order are variable. A machine that is there anyway costs depreciation and floor space with or without an order; energy and tooling do move with spindle hours. The contribution margin is therefore a measure for short-term decisions in which fixed costs stay the same. When a decision changes fixed costs, such as an extra shift or a new machine, that change is counted separately.
How does contribution margin work in practice?
The contribution margin helps when you weigh up an order below your normal price. If capacity is idle and the order covers its variable costs, it contributes to costs that run on anyway. Whether that is wise depends on what the order displaces, whether better-paying work for the same machine is coming, and what price level the customer will expect next time. When one machine is the bottleneck, orders are compared on contribution per hour on that machine, not per part or per order.
What is contribution margin often confused with?
The contribution margin is not the margin on full cost, which does include fixed costs. An order with a positive contribution can still lose money on full cost. Nor is it gross margin, which deducts the cost of sales from revenue; which costs sit in the cost of sales differs from one set of accounts to another.
Frequently asked questions
Should you take an order below cost?
Sometimes that is defensible: when the order covers its variable costs, the capacity would otherwise stand empty and it displaces no better-paying work. Record why you did it, so a temporary price does not become the new price level.
What does an order actually earn?
In the short term its contribution: revenue less material, subcontract work, tooling and other variable costs. In the long run all orders together also have to carry the fixed costs and the profit; that is where full cost comes in.
Is labour a variable or a fixed cost?
Either, depending on the contract and the time frame. Permanent staff cost the same in the short term, with or without an order. Overtime, premiums and agency staff needed only for an order are variable.