What is Contribution Margin?
Contribution margin represents the incremental profit generated for each product/unit sold.
It is a cost accounting calculation that tells a company the profitability of an individual product. The formula for contribution margin is the sale price of the item minus the variable costs.
How to Calculate the Contribution Margin?
On a per unit basis, the contribution margin is computed as the difference between the sale price of a product and the variable costs associated with its production and sales process.Contribution\space Margin = P - V
Where P = Price per Product and V = Variable Cost per Product
Contribution is a measurement through which we can understand how much a company’s net sales will contribute to the fixed expenses and the net profit after covering the variable expenses. So, while calculating the contribution, we deduct the total variable expenses from the net sales.
While the above formula is used on the per unit sales and per unit variable cost figures, another mathematical representation is used that computes the figure on the overall financial numbers:
Contribution Margin Examples
ABC Company has net sales of $500,000. It has sold 50,000 units of its products. The variable cost of each unit is $5 per unit. Find out the contribution, contribution margin per unit, and contribution ratio.
We will simply use the contribution margin ratio formula to find out the contribution margin per unit and contribution ratio.
- Company has net sales of $500,000.
- Number of units sold was 50,000 units.
- Selling price per unit would be = ($500,000 / 50,000) = $10 per unit.
- Variable cost per unit is $5 per unit.
- Contribution margin per unit formula would be = (Selling price per unit – Variable cost per unit) = ($10 – $5) = $5 per unit.
- Contribution would be = ($5 * 50,000) = $250,000.
- Contribution margin ratio formula would be = Contribution / Sales = $250,000 / $500,000 = 1/2 = 50.00%.
Uses of Contribution Margin
The contribution margin concept can be applied throughout a business, for individual products, product lines, profit centers, subsidiaries, distribution channels, sales by customer, and for an entire business.
Analyzing the contribution margin helps managers make several types of decisions, from whether to add or subtract a product line to how to price a product or service to how to structure sales commissions.
If a product’s contribution margin is negative, the company is losing money with each unit it produces, and it should either drop the product or increase prices. If a product has a positive contribution margin, it’s probably worth keeping.
Low values of contribution margins can be observed in the labor-intensive industry sectors like manufacturing as the variable costs are higher, while high values of contribution margins are prevalent in the capital-intensive sectors.