Contribution MarginDefined with Formula, Examples & Calculations
What is Contribution Margin?
Contribution margin represents the revenue a business earns off of sales once variable costs are removed.
This can be calculated either for gross sales, for a product line, or per unit.
The contribution margin can be calculated by taking the selling price of a product and then subtracting the variable costs it takes to make it.
This is often known as the dollar contribution per unit, and it is a valuable metric to see how a particular product contributes to a firm’s profits.
The contribution margin can be expressed as either a percentage or as a dollar amount.
The contribution margin accounts for variable costs.
Once these are removed, any remaining amount can be used to cover fixed costs.
If there is any remaining amount after this, it will be profit generated by the sale.
The Formula for Calculating Contribution Margins Ratio
In order to compute the contribution margin, the sales price of a product is taken, and then any variable costs associated with producing and selling it are subtracted from this number.
Contribution Margin = Sales Revenue – Total Variable Costs
In order to express this as a percent, the following equation would be used:
Contribution Margin Ratio = (Sales Revenue – Variable Costs) / Sales Revenue
What Does a Contribution Margin Show You?
The contribution margin is the basis for determining sales prices and finding the break-even point for a product line.
By finding its contribution margin, a business can effectively find the revenue remaining after variable costs are accounted for to find what it has left over to cover fixed costs and provide profits.
Fixed Costs Versus Variable Costs
Companies depend on effectively knowing and separating their fixed and variable costs in order to determine price and make appropriate business decisions.
This is also at the core of calculating contribution margins.
A fixed cost is often a one-time cost, such as purchasing plant equipment to produce a product.
This expense will remain the same no matter how many units it produces, and as a result, its relative cost will continuously shrink in comparison to the variable cost of producing each unit as the number made grows.
Recurring costs such as utilities may also be fixed costs because they do not have a direct relationship with the number of units that are produced and sold.
Examples of this may be water for cooling machinery.
The utility provider may provide a fixed cost every month for the factory regardless of how much it actually uses.
This means whether or not the company produces and sells one or 100,000 units, the price of the utility will remain the same.
Another example would be the accountant that handles payroll for factory workers.
No matter what amount of products the company makes, the salary for the accountant will remain the same.
This is why the salaries for administrative workers are generally a fixed cost.
On the other hand, if the utilities or salaries were to increase in proportion with the number of units produced or sold, this would be a variable cost.
For example, the wages of employees that are paid in relation to the number of units they produce are a variable cost.
All variable costs will be included in determining the contribution margin and are key in making decisions regarding costs and profitability.
On the other hand, once a fixed cost occurs, it is sunk (cost) and should be disregarded in making these decisions for a company’s future.
How Is the Contribution Margin Used?
The contribution margin is an extremely valuable tool for conducting a break-even analysis.
This is the number of units that need to be sold for a business to break even on revenue vs. costs.
To calculate this, a business divides its fixed costs by the contribution margin per unit.
Generally, fixed costs are high, and a company will look for a high contribution margin to cover them.
As a result, a business will look to the contribution margin as an important tool in determining the pricing of products.
The contribution analysis can also be used in streamlining a company’s products and making decisions about what new products it should pursue.
By looking at the contribution margin for each of its product lines, a company can determine which are the most profitable.
It can do the same in deciding what new products it may wish to invest in.
If, for example, a mattress manufacturer found that the contribution margin for producing a new type of gel mattress was higher than producing a new line of memory foam mattresses, it would choose the former because it has a higher potential for profit.
This type of decision-making is crucial for companies that produce a wide range of products in order to allocate resources efficiently.
An extremely low or even negative contribution margin shows that either a product’s sales price should be increased or it is not viable and should be rejected.
However, in labor-intensive industries that have high variable costs and low fixed costs, contribution margins may naturally be low.
On the other hand, in capital-intensive industries such as manufacturing that have low variable costs and high fixed costs, the contribution margin will generally be quite high.
For investors, contribution margin can be extremely important because it can help determine how dependent a company is on certain high-performing products.
This can allow a wary investor to pay attention to if a competitor introduces a similar product or the company begins shifting its focus away from such a product which will generally affect share prices.
Contribution Margin Examples
Suppose a company had a machine that cost $15,000 and makes yo-yos.
One yo-yo requires $.50 of raw materials, such as plastic and string.
It also requires $.15 in labor and $.10 in electricity.
The variable cost per yo-yo is made up of these three components.
This means the variable cost for one yo-yo is $.75 ($.50 + $.15 +$.10).
If the company manufactures 500 yo-yos, there will be $375 in variable costs ($.75 * 500 = 375).
If 15,000 yo-yos are manufactured, then the total variable cost would be $11,250 ($.75 * 15,000 = $11,250).
Variable costs will increase directly in proportion to the number of units produced.
But, the variable costs are not the only costs of making the yo-yos; a machine is necessary to make the yo-yos as well.
The machine it requires costs $15.000, and this is a fixed cost of manufacturing yo-yos.
Being a fixed cost, this cost does not change with the number of units being produced.
Therefore, fixed costs are not considered when calculating the contribution margin.
If the company manufactures 15,000 yo-yos with the machine, which results in $11,250 in variable costs and $15,000 in fixed costs, the total manufacturing costs for the yo-yos is $26,250.
The total manufacturing cost can then be divided by the number of yo-yos being manufactured to get the per-unit cost of $1.75 ($26,250/15,000 = $1.75).
Then, if the sales price of one unit is $2.25, the profit per unit would be calculated by subtracting the total cost per unit from the sales price ($2.25 – $1.75 = $.50). The profit per unit is $.50.
Net Profit Per Unit = Sales Price – Total Cost Per Unit
The formula for calculating the contribution margin is different than the formula for calculating the profit since the contribution margin does not take into account fixed costs.
The contribution margin is calculated by taking sales revenue minus total variable costs.
To obtain the contribution margin per unit, divide the contribution margin by the units produced or sold.
The contribution margin will show the incremental profit for each unit.
For the yo-yos, the contribution margin would be $22,500 ($33,750 – $11,250 = $22,500.
The contribution margin per unit would be $1.50 ($22,500/15,000 = $1.50).
The contribution margin will be fixed on a per-unit basis no matter how many units are produced.
n contrast, the net profit per unit can increase or decrease in a non-linear manner depending on the number of units sold since net profits include fixed costs.
For instance, if we change the number of yo-yos manufactured in the previous example from 15,000 to 30,000, the net profit per unit will change.
The total fixed cost will remain the same at $15,000.
However, the fixed cost per unit will be $.50 ($15,000/30,000 = $.50) The variable costs per unit would be $.75.
This means the total cost per unit is $1.25.
The sales cost is still $2.25. This means the net profit per unit is $1.00 ($2.25 – $1.25).
This shows that manufacturing twice the number of units increased the net profit per unit from $.50 per unit to $1.00 per unit.
However, the contribution margin is the same since it is calculated using only variable costs, not fixed costs.
This shows just how much profits can be increased by increasing sales since the fixed costs per unit decrease as sales increase.
- A contribution margin is the part of the revenue from selling a good that exceeds the variable costs used in making it. As a result, this amount can contribute toward covering fixed expenses.
- The size of a company’s contribution margin is often dependent on its industry. Companies in industries with low fixed costs generally require a lower contribution margin to cover them, and the reverse is true in industries with high fixed costs.
- Contribution margins are critical in determining a company’s break-even point and in setting pricing.
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Alamo Colleges District "Contribution Margin, Break-even Analysis, Product Costing Methods" Page 1 - 4. December 6, 2021
Pacific Lutheran University "Contribution Margin" Page 1 . December 6, 2021
Harvard Business School "Contribution Margin: What It Is, How to Calculate It, and Why You Need It" Page 1 . December 6, 2021