The contribution margin is the portion of the product’s revenue that exceeds the variable cost of producing that product and generating that revenue. It is an accounting term that helps business owners and managers track product profitability. The contribution margin is important to understand because it shows how much of the product revenue is available to cover fixed costs and contribute to the company’s profit.
Definition and Examples of Contribution Margin
To understand what contribution margin is, you first need to grasp the basics of how companies define their costs. Companies classify the costs of producing products and delivering services into two main categories: fixed costs and variable costs. Fixed costs do not change with the level of production, while variable costs do.
The contribution margin is the revenue generated after covering the variable costs of production, such as materials costs and direct labor costs. This excess revenue is available to cover fixed costs. It can also include the company’s profit if the amount exceeds the total amount of fixed costs.
Note: Contribution margin can be measured at the unit level or for the company as a whole.
Unit Contribution Margin vs. Total Contribution Margin
You can calculate the contribution margin for individual products, known as unit contribution margin, or for the company as a whole, referred to as total or gross contribution margin.
To calculate the unit contribution margin, subtract variable costs per unit from the selling price per unit.
Unit Contribution Margin = Price – Variable Cost per Unit
For example, if the price of a packaged drink is $1.50 and the variable costs for materials, labor, and overhead for that one bottle are $1, the unit contribution margin is $0.50. This means that each packaged bottle produced and sold by the company contributes $0.50 towards covering fixed costs and generating profit.
The total contribution margin measures the same thing but at the aggregate level instead of individual values. The total contribution margin is calculated by subtracting total variable costs from total sales (or revenue).
Total Contribution Margin = Sales – Total Variable Costs
For instance, suppose your company manufactures and sells one million bottles of a drink, each priced at $1.50 with variable costs of $1. Total sales equal one million bottles multiplied by $1.50 per bottle, totaling $1.5 million. The total variable costs equal $1 per bottle multiplied by one million bottles, totaling $1 million. The total contribution margin is $1.5 million minus $1 million, which equals $500,000.
You can verify that the total contribution margin and unit contribution margin measure the same information just at different levels by comparing them in this example. $500,000 in total contribution margin is equivalent to one million bottles multiplied by the unit contribution margin of $0.50 ($0.50 × 1 million = $500,000).
How Contribution Margin Works
The contribution margin is a cost-volume-profit (CVP) analysis tool that helps companies assess how costs, sales volume, and price affect operating profitability. The equation for determining operating profitability is:
Operating Profit (or Income) = Sales – Total Variable Costs – Total Fixed Costs
By looking at operating profit this way, a company can study how changes in sales, variable costs, and fixed costs impact operating profit.
Now, it’s important to remember that costs are divided into two main categories: fixed costs and variable costs. Variable costs are subtracted from sales to arrive at the contribution margin.
The step
After finding the contribution margin, the next step will be to subtract fixed costs. This equation can be seen as follows:
Operating profit = Contribution margin – Total fixed expenses
To see an example of how a company can use the contribution margin in analyzing operating profit, let’s continue using the packaged beverage example from above.
Let’s assume you have a beverage packaging company with $300,000 in fixed costs, which are costs that do not change with the level of production. Common examples of fixed costs include salaried employees, rent or lease payments, and insurance premiums.
Your contribution margin is $500,000. You subtract $300,000 in fixed costs to get $200,000 in operating profit. Since your total contribution margin is $500,000 (which is what you get when subtracting variable costs from sales), you can see that you’ve generated enough revenue to cover both the fixed and variable costs of production and generate an operating profit of $200,000.
Note: The contribution margin is also often used to determine the break-even point and the sales volume required to achieve a target profit.
Finding the Break-even Point
The contribution margin can be used to see how many units the company needs to produce and sell in order to reach the break-even point. The break-even point is when the company recoups the cost of providing those products or services.
To find the number of units needed to reach the break-even point, simply divide the company’s total fixed costs by the contribution margin per unit. This allows managers and business owners to know the sales level required to cover all costs and start making a profit.
In our packaged beverage example, the break-even point in units is 600,000 bottles ($300,000 / $0.50). At 600,000 bottles, we generate just enough revenue to cover operating costs. We will operate at a loss if we sell fewer bottles and make a profit if we sell more.
Achieving Target Profit
The contribution margin can also be used to determine how many units the company needs to sell to achieve a targeted operating profit.
The formula for that is similar to the formula for determining the break-even point, but with the addition of the target income:
(Fixed costs + Target income) / Contribution margin per unit = Total units required
For our beverage example, let’s assume we have a goal of achieving a target income of $1 million. To determine how many bottles we need to sell to achieve that, we add the fixed costs of $300,000 to the target income of $1 million for a total of $1.3 million. We then divide that by the contribution margin per unit of $0.50: ($300,000 + $1 million) / $0.50 = 2.6 million bottles. We will need to sell 2.6 million bottles to achieve a targeted operating profit of $1 million.
Contribution Margin vs. Contribution Margin Ratio
The contribution margin can be expressed in dollars as we have seen, but it can also be presented as a percentage.
The expression of the contribution margin as a percentage is called the contribution margin ratio. This is the percentage of revenue remaining after covering variable costs. It can be calculated using either the contribution margin per unit or the total contribution margin.
On a per unit basis, it is calculated by dividing the contribution margin per unit by the unit selling price. We can calculate it from the packaged beverage example as follows: $0.50 / $1.50 = 0.33 or 33%.
Using the total contribution margin, we can divide the total contribution margin of $500,000 by the total sales of $1.5 million. For example, we can divide the total contribution margin of $500,000 by the total sales of $1.5 million to get $500,000 / $1.5 million = 0.33 or 33%.
Once
It is not a coincidence that we get the same ratio because it measures the same information only at different levels.
Source: https://www.thebalancemoney.com/what-is-contribution-margin-5187229
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