The contribution margin is part of the break-even analysis and is used in the overall cost and sale price planning for products. The contribution margin is the selling price per unit, minus the variable cost per unit. It is also called the dollar contribution per unit and indicates how a particular product contributes to the overall profit of a company.
Contribution margin is an accounting term that helps business owners and managers track product profitability. It is important to understand because it shows how much a product’s revenue is available to cover fixed costs and contribute to the firm’s profit.
Formula and Calculation of Contribution Margin
The formula for the contribution margin is the difference between the sale price of a product and the variable costs associated with its production and sales process:
Contribution margin = revenue – variable costs.
For example, if the price of a product is $10 and the unit variable cost is $5, then the unit contribution margin is $5. It is important when doing this calculation, that you take a traditional income statement and recategorize all costs as fixed or variable.
What Contribution Margin Can Tell You?
The contribution margin can be used to determine the selling price range of a product, and the profit levels that can be expected from the sales, the structure of sales commissions paid to sales team members, distributors, and commission agents.
Fixed Cost vs. Variable Cost
Businesses can incur two types of costs when they produce their goods, fixed and variable costs. Fixed costs are expenses that remain the same no matter how much a company produces. These costs can include things like rent, property tax, insurance, and depreciation. Variable costs are expenses that change based on how much a company produces and sells. Variable costs include things like labor, utility expenses, commissions, and raw materials.
Example of Contribution Margin
The contribution margin is used to quickly see the number of units a firm needs to produce and sell in order to break even. The break-even point is when a business recoups the cost of offering that product or service. For an example of how to calculate a contribution margin let’s suppose that a company sells a single product with the selected data of the company given below:
- Sales prices: $50 per unit
- Variable manufacturing cost: $10 per unit manufactured
- Variable selling and administrative cost: $5 per unit sold
- Number of units manufactured and sold during the period: 1,000 units
Contribution margin per unit = sales price per unit – variable expenses per unit
= $50 – $15
= $35 per unit
Contribution margin for period = $35 times 1,000 units sold = $35,000
Uses of Contribution Margin
Contribution margin helps company management select from among several possible products that compete to use the same set of manufacturing resources. If the contribution margin for one product is higher than for another product, then the former will be given production preference.
Contribution Margin for Investors
For investors, the contribution margin is important because it is a percentage that represents the profitability of a particular product. It subtracts the variable expenses of producing the product from the revenue it creates and divides the difference by the revenue.
The contribution margin is used by companies to help them determine which products are more profitable and by using this information they can determine which product to keep and which product won’t bring in enough revenue. For investors, the contribution margin helps them compare two different companies and the profitability of their products.
How Do You Calculate the Contribution Margin?
The formula for the contribution margin is calculated as Revenue – Variable Costs = contribution margin.
What Is a Good Contribution Margin?
A good contribution margin is 100% and the closer the contribution margin is to 100% it means that a company is covering its overhead costs with money on hand.
What Is the Difference Between Contribution Margin and Profit Margin?
The difference between contribution margin and profit margin is that the contribution margin measures the profitability of each individual product that a business sells whereas the profit margin is the amount of revenue that remains after the direct production costs are subtracted.
