The contribution margin is the selling price of a product minus the variable costs required to produce that product. Learn how the contribution margin can be used to cover your fixed costs and—once those costs are covered—the contribution margin becomes profit.
- On the way to the studio today, I stopped at a recognizable fast food establishment to get some food, fast. Every time I go into this place, they're always trying to up size me. Larger drink, larger fries. - You don't want larger? You don't want bigger? - If I wanted bigger I wouldn't ordered bigger. Why do they do that? - Well dear brother, it's all about accounting. - What? What does a larger drink have to do with accounting? - To explain, let's step back for a moment and talk about a concept called contribution margin. - [Man On Right] Ah, I know what that is. The Contribution margin is the selling price of a product less the variable cost required to produce that product.
The difference, the Contribution Margin, is then used to cover your fixed costs and once those costs are covered, the Contribution Margin becomes profit. - Exactly. Now you can use information about about selling price, variable costs, and fixed cost to compute the number of units required before a company breaks even. The lower the break-even point, the sooner a company begins to generate profits. - [Man On Right] And the higher the contribution margin, the lower the break-even point. In other words, the more that contributes to cover fixed cost. Higher contribution margin, the sooner we cover our fixed cost.
- Let's do a simple numerical example to illustrate. Suppose that you go to a fast food restaurant and purchase a meal; burger, fries, and a drink. Let's suppose the meal cost you seven dollars and the variable cost associated with that meal, the hourly wages, the food, the packaging, four dollars. - Okay, that means that the contribution margin for each meal is three dollars. We're still waiting to see the connection that this has with the larger drink they were still trying to sell me. - Okay hang on. Any idea what the contribution margin is on a hamburger or a drink, or on fries? - Oh I imagine you can enlighten me there.
- [Man On Left] I can as with many other things. Now the contribution margin on hamburger's about 50 percent. That is, if you pay four dollars for a burger, about two dollars of that covers the variable cost, and two dollars contribute to cover fixed cost. The contribution margin on fries, about 70 percent. Then the contribution margin on a drink, about 90 percent. - Ah, up size the fries and the drink, up size the contribution margin. - [Man On Left] Let's work the numbers; up size the fries and pay 50 cents more. Up size the drink and pay 50 cents more. Now a meal that costs you a dollar more, is now contributing 80 cents to cover fixed cost.
- And if they'dve asked me to up size my burger and pay a dollar more, that would've only contributed 50 cents towards covering fixed cost. I guess that's why they don't ask if I want to up size my burger. They're much more interested in selling more fries and more drinks. Higher contribution margin. - Exactly. You see the same thing happening in grocery stores. You never see milk at the front of a grocery store. You always have to go to the back of the store to find the milk. Why? Milk is a low contribution margin item. - But, you have to walk past a lot of high contribution margin items to get to the milk.
The hope is that a high contribution margin item will catch your eye as you're looking for the milk. - [Man On Left] In fact, next time you're at a check out counter at a grocery store, look around. While you're waiting for your turn to check out, you'll notice that you're being tempted. Tempted by a lot of high contribution margin items. - Grocery stores make a lot of money on impulse buys made at the last minute while you're standing, waiting for your turn at the checkout counter. At the checkout counter are high contribution margin items. - One more example, convenience stores; the ones where you gas up and if you go in you can buy snacks and such.
They don't make a lot of money on gas. Gas is a low contribution margin item, but if they can get you in the store, then you'll buy high contribution margin items. Chips, candy, drinks. - Hey at the convenience store where I buy my gas, they have a punch card that I get punched each time I fill up that is good for a free car wash once I get ten punches. - Well I hate to break it to you, but they don't care about how clean your car is. They care about getting you into the convenience store where they can tempt you with high contribution margin items. - Ah, so it is about accounting.
Companies don't offer add-ons at random. They're not up sizing low contribution margin items. They're not putting low contribution margin items near the check stand. They know exactly what they're doing. - Yeah they do know exactly what they're doing. And now you know exactly what they're doing as well.
Skill Level Beginner
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