Understanding Contribution Margin

How much does it cost you to make and sell one more product?

Today I want to tell you about contribution margin, and how understanding it will tell you a lot about the way products are price — and about how you can price your products profitably.

Contribution margin may not be a term you hear every day (unless like me you work in a Finance department) but the concept is easy enough. Contribution is the profit you have left over to cover fixed costs from selling a product after you’ve covered the variable costs of producing that product you just sold.

I know I’ve just defined one term by introducing two more, but these are pretty self explanatory. Fixed costs are the costs you’ll have no matter how much of your product you actually sell. Variable costs are the costs you incur each time you sell your product. Let me illustrate with three examples for very different businesses.

Say you have a business hand-making chainmail jewelry. Your fixed costs would be fairly low: tools, a website, etc. However, because the products are hand made, the aren’t significant savings due to scale. Every time you make a product, you have to invest the time to put it together and the supplies to make it. Because your labor is the biggest cost, hand-made jewelry is a high variable cost business.

Imagine that instead you have a sandwich shop. It’s open from 11am to 7pm, and you need to pay your rent and your friendly sandwich maker regardless of whether you sell one sandwich or one hundred. You sell your sandwiches for $9 (or $12 for a combo with chips and drink!) The cost to make the sandwich itself is only $3 ($4 for the combo) giving you a contribution margin of 66%, which is good because as I mentioned, you need to pay your rent and your sandwich maker out of that profit.

Finally, consider an author who has published an ebook on Amazon. All of his expenses are invested in writing and publishing the actual book. Since each purchase results in a digital download which incurs no additional cost, the contribution margin for each sale is 100%. This dynamic is the same for a number of other things in the digital world from software to entertainment. In these business models, the cost comes with the initial production before any units are sold, but then the sale of each unit comes with no incremental cost.

What does all this tell you about pricing?

There are going to be different pricing and discounting strategies that will make sense for products with higher or lower contribution margin.

If you have lower contribution margins, like the hand-made jewelry business, you would want to be very cautious with using discounts to drive sales. Yes, a discount might make a difference between “sale” and “no sale” on a particular day, but since you incur the full cost of production for every unit you sell, if you sold for 20% off you would make significantly less profit than at full price. It might under certain circumstances be worth it. Like anyone else, a business owner would rather be working than not working. But in a low contribution margin business like that, discounting is effectively taking a pay cut on your labor.

At the other end, you can see why independently published authors often sell books at very low prices in the hopes of making it back on volume. Given that selling an additional ebook has zero additional cost, it’s still worth it to sell at $0.99 each if that’s what it takes to get people to choose your book.

This does not mean that discounting should be automatic in an extremely high contribution margin business.

Microsoft is an example of a company which historically sold a product (software) which has almost no marginal cost. (In the case of software installed directly onto the computer when it was sold, it really was pretty much zero variable cost. In the case of boxed software, it was the cost of the box, CD or floppies, and manual. The reason why Microsoft has been profitable from the very beginning, and never struggled with cashflow, is that they have successfully commanded good prices for products which have little or no variable cost and sold huge volumes of them. Contribution margin has contributed a lot to Microsoft over the years!

In the case of the author, a key question is whether the author has the visibility to win more sales with a low price. If his book is going out to thousands of potential readers in a discount newsletter, or if he’s already highly visible, then putting his book at a low price may help him win volume over other books which are priced higher. (eBooks from traditional publishers often have high prices in order to avoid undercutting the prices of their paperbacks and hardcovers.)

However, if the author is likely to only sell his book to people in his social network, then announcing a discount will only result in selling copies he would have sold anyway at a lower price.

Our sandwich shop example falls in the middle. On the one hand, they want to avoid having their site and labor idle. They are paying their sandwich maker whether anyone comes in or not. This is why restaurants often offer deals in the off-hours such as “happy hour” discounts which are offered earlier than prime dinner and drinks time. Offering discounts may seem attractive to a restaurant seeking to keep their location busy. But as Starbucks recently found, sometimes these discounts bring in opportunistic customers and don’t actually drive enough incremental sales to benefit the company.

Thinking carefully about how much it costs you to make and sell one more product can help you assess for your own business what pricing and discounting choices you should make in order to remain as profitable as possible.