The contribution margin measures the difference between the sales price of a product and the variable costs per unit. Put simply, when a business manufactures a product or offers a given service, there is a cost attached to it. When you subtract that variable cost of delivering a product from the sales price of the product, the remainder is the contribution margin.
Contribution margin is more of a managerial ratio because it allows management to determine how effectively they can combine all the factors of production to produce a given product spending the least amount of money in the process.
Contribution margin can be stated as either a gross or per-unit amount and it’s used to measure how much a specific product contributes to the overall profit of the company.
Contribution Margin Formula
Calculating the contribution margin of a company is a simple process, as all you need to do is subtract the total variable costs from the net sales revenue figure of a business.
You can also express the contribution margin as a percentage by using the following formula:
Management may also want to calculate the contribution margin on a per-unit basis. For this, you would use the same formula, but input the values for one unit:
The sales revenue is net sales – total sales less any returns, discounts, or allowances. The net sales figure will be reported on the company income statement either as net sales specifically or as the only sales figure.
The second element of the contribution margin formula is the variable costs. Variable costs are costs that change in a company with an increase in production.
Examples of variable costs include the cost of raw materials, cost of labour, shipping etc. The more the business produces the more it will spend on raw materials and labour, and that is the reason why this cost varies with an increase in production.
Variable costs are not typically shown on company financial statements and the usual way to get the figures is to tally them up from the income statement. It’s not common to issue income statements that split variable and fixed costs, but some companies do separate them.
An example of a fixed cost would be rent paid for a company’s warehouse. It doesn’t matter how many products they produce, the rent will cost the same.
Contribution Margin Example
Ironbridge Containers registered sales worth $2,000,000 in the last financial year that ended in July 2018. The following are the company variable costs:
- Shipping cost: $200,000
- Utilities: 100,000
- Production supplies: $300,000
- Labour costs: $400,000
Let’s calculate the gross contribution margin for Ironbridge:
Ironbridge has $1,000,000 left to clear its fixed costs after paying its variable costs of $1,000,000. Assuming fixed costs are $500,000, this would leave the company with $500,000 in profit at the end of the year.
To work out the per-unit contribution margin, management could either use the formula above and use the sales price per unit and variable cost-per-unit, or they could divide the $1,000,000 contribution margin by the number of units sold.
Contribution Margin Analysis
The contribution margin is a managerial ratio that is used to determine the breakeven point for a product and from there they can make informed decisions on product pricing. A business can also use this ratio to close down product lines that are not showing profits and invest in profitable product lines instead.
For example, if a company’s net sale exceed variable costs for the production of a given product, it would mean that the business would not have enough money to pay for its fixed costs, and shutting down the production of that product is an option to improve the CM.
Investors, can use this ratio to determine the effectiveness of a company to make profits when deciding whether to invest. Through the calculation of the variable costs and profit per unit sold, they can use the analysis to predict the estimates for the upcoming year.
Just as with any other financial ratio, the calculation of the contribution margin could yield a low or higher value. When a business registers a higher contribution margin value, it would mean that it has enough resources available to meet its variable as well as fixed costs.
A low contribution margin is unfavorable for a business, and it implies that the product the business is producing or its departments is not profitable.
Contribution Margin Conclusion
The contribution margin is a vital managerial measure that determines the amount of money left to clear direct costs after meeting the variable costs of a business. The below points are worth bearing in mind as a quick recap of what it is, why it’s used, and how to use it:
- To calculate the contribution margin of a company subtracts variable costs from the net sales of a business.
- Variable costs are costs that change in a company with an increase in production.
- Fixed costs do not change as production increases.
- A low contribution margin is unfavourable for business, and it implies that the product the business is producing or its departments is not profitable.
- Higher contribution margin value indicates the business has enough resources to meet its variable as well as fixed costs.
- Contribution margin ratio does not feature in a company’s financial statements.
Contribution Margin Calculator
You can use this calculator to calculate the contribution margin for a company by entering the value of net sales and variable costs.
FAQs
1. What is the contribution margin?
The contribution margin is the amount of money left to clear direct costs after meeting the variable costs of a business. Put simply, it’s the amount of money a company has available to cover all costs associated with making and selling a product, minus the variable costs.
2. How do you calculate contribution margin?
To calculate the contribution margin, subtract the sales revenue from the variable costs.
The formula would be:
Contribution Margin = Sales Revenue − Variable Costs
3. What does the contribution margin tell you?
The contribution margin tells you how profitable a product is in relation to the variable costs associated with making it. In other words, it shows you how much money you’d make (or lose) if you sold all the products you made, minus the variable costs of making them.
4. What is a good contribution margin?
The closer a contribution margin percent, or ratio, is to 100%, the more profitable the product or line of business is. This means that the company has covered all costs associated with the product, including both the variable and fixed costs. A contribution margin ratio of 50% or more is considered good.
5. What is the difference between contribution margin and contribution margin ratio?
The difference between the two is that the contribution margin ratio is the percentage of sales revenue that goes towards covering the variable costs. While the contribution margin is the total dollar value of the money left over after variable costs have been deducted.
