Maximizing Profits : A Simple Guide to Contribution Margin
This blog gives a brief overview of Contribution Margin (CM) and how to calculate it for your automotive aftermarket business
When running a successful automotive parts business, understanding your financial metrics is crucial. One such metric is the contribution margin, which can help you determine the profitability of individual products and make better decisions about inventory and pricing.
In a nutshell, the contribution margin (CM) is the amount of money you make from selling a product after subtracting the associated variable costs. The remaining money can then be used to cover fixed costs (like rent and salaries) and eventually contribute to your profit. In other words, it's a key indicator of how profitable a particular product is, making it an essential figure to track in your automotive parts business.
Calculating Contribution Margin in the Automotive Parts Aftermarket Industry:
The formula for calculating the contribution margin is simple in theory.
Imagine one of your best-selling products is a specific set of brake pads. To calculate the contribution margin, you first look at your current retail price, $50.
Now let’s look at your variable costs. You have 3 suppliers that sell these brake pads. The lowest is $22 with Supplier A . The average cost to ship from that supplier is $8.
When you sell your brake pads on eBay, it accounts for another 13% + $0.30/order, or $6.80. Given the demand for these brake pads, you decided to run this as a promoted listing, which cost you an additional 10%, or $5.
To get your contribution margin for your brake pads, you need to understand the margin, after ALL variable costs, on each sale. Then, you can take this and average it over the total number of sales from a certain period. Then you have your contribution margin.
Example CM = $50 - ( 22 + 8 + 6.80 + 5 ) = $50 - 41.80 = $8.20 CM/unit
While Contribution Margin is a critical metric for all businesses, it is especially relevant in eCommerce. By knowing your Contribution Margin, you can take a data-driven approach to:
At its core, the contribution margin helps aftermarket sellers understand the profitability of individual products or services. By calculating the contribution margin, sellers can determine which products contribute the most to covering fixed costs and generating profit. This allows businesses to focus on promoting high-margin items while potentially discontinuing or reevaluating low-margin products that may hold them back.
In our example, the product had an $8.20 contribution margin of 16.4%. The brake pad set could then be compared to other brake pad sets to see about promoting or ending its sales.
For automotive aftermarket sellers, the contribution margin plays a significant role in a well-thought-out pricing strategy. By analyzing the margin of each product, sellers can identify which items can be priced higher without affecting demand, as well as items that may need to be priced lower to remain competitive. This will ultimately help businesses maximize their overall profitability.
By knowing the demand curve over the past 3-12 months and the contribution margin of the brake set, we can determine the profit generated at different price points.
The contribution margin helps automotive aftermarket sellers determine how to allocate resources, such as marketing budget, employee time, or warehouse space, to maximize their return on investment. By focusing resources on high-margin products, businesses can maximize their profits while minimizing costs.
Understanding the break-even point is essential for businesses to ensure they cover their fixed costs and start generating a profit. The contribution margin ratio, calculated by dividing the contribution margin by sales revenue, allows sellers to determine how many units they need to sell to break even. Knowing this information can help automotive aftermarket sellers set realistic sales targets and take the necessary steps to achieve them.
Only selling the example brake set and with $400 in average daily fixed costs, we’d know we needed to sell 56 sets a day to break even ($400 / $7.20). This would let us set a minimum sales target.
A contribution margin is a valuable tool for automotive aftermarket sellers when making decisions related to business growth. Whether considering expanding product lines, investing in new equipment, or launching a marketing campaign, the contribution margin can provide insights into the potential return on investment. By focusing on products and initiatives with the highest contribution margin, sellers can optimize their growth strategy and make better-informed decisions.
We understand that this might feel a little overwhelming, but we are here to help! If you want to better understand how your company can calculate and understand your contribution margin, let’s chat.