Contribution margin represents the incremental profit generated for each product/unit sold and is computed as the selling price per unit minus the variable cost per unit. Also called as dollar contribution per unit, the measure indicates how a particular product contributes to the overall profit of the company. It represents an alternate way to represent the profitability potential of a particular product offered by a company and is the portion of sales that helps to offset fixed costs.
Contribution Margin Formula
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 margin = Sales (or Revenue) − Variable Costs
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 = (Net Product Revenue - Product Variable Costs) ÷ Product Revenue
Contribution Margin Example
Say a machine for manufacturing ink pens comes at a cost of $10,000. Manufacturing one ink pen requires $0.2 worth of raw materials like plastic, ink and nib, another $0.1 goes towards the electricity charges for running the machine to produce one ink pen, and $0.3 is the labor charge to manufacture one ink pen. These three components constitute the variable cost per unit. The total variable cost of manufacturing an ink pen comes to ($0.2 + $0.1 + $0.3) = $0.6 per unit. If a total of 100 ink pens are manufactures, the total variable cost will come to ($0.6 * 100 units) = $60, while manufacturing 10,000 ink pens will lead to a total variable cost of ($0.6 * 10,000 units) = $6,000. Such total variable cost increases in direct proportion to the number of units of the product getting manufactured.
However, the ink pen production will be impossible without the manufacturing machine which comes at a fixed cost of $10,000. This cost of machine represents a fixed cost (and not a variable cost) as its charges do not increase based on the units produced. Such fixed costs are not considered in the contribution margin calculations.
If a total of 10,000 ink pens are manufactured using the machine at a variable cost of $6,000 and at a fixed cost of $10,000, the total manufacturing cost comes to $16,000. The per unit cost will then be computed as $16,000/10,000 = $1.6 per unit. If each ink pen is sold at a price of $2 per unit, the profit per unit comes to (Sale Price – Total Costs) = ($2.0 - $1.6) = $0.4 per unit.
However, contribution margin does not account for fixed cost components and considers only the variable cost components. The incremental profit earned for each unit sold as represented by contribution margin will be (Sale Price – Total Variable Costs) = ($2.0 - $0.6) = $1.4 per unit.
A key characteristic of the contribution margin is that it remains fixed on a per unit basis irrespective of the number of units manufactured or sold. On the other hand, the net profit per unit may increase/decrease non-linearly with the number of units sold as it includes the fixed costs. In the above example, if the total number of ink pens manufactured and sold doubles to 20,000, the total cost (fixed + variable) will be ($10,000/20,000 + 0.6) = $1.1 per unit. The profit per unit will come to (Sale Price – Total Costs) = ($2.0 - $1.1) = $0.9 per unit. Essentially, doubling the number of units sold from 10,000 to 20,000 (two times) has increased the net profit per unit from $0.4 to $0.9 (that is, 2.25 times).
However, the contribution margin, which gets calculated with respect to only the variable cost, will be (Sale Price – Total Variable Costs) = ($2.0 - $0.6) = $1.4 per unit. The contribution margin remains the same even when the number of units produced and sold has doubled. It provides another dimension to asses how much profits can be realized by scaling up the sales.
Fixed Cost versus Variable Cost
One time cost towards such machinery (as cited in the above scenario) is a typical example of fixed cost that leads to variable profitability based on the number of units sold. Other examples include services and utilities that may come at a fixed cost and do not have an impact on the number of units produced or sold. For example, if government offers unlimited electricity at a fixed monthly cost of $100, then manufacturing ten units or 10,000 units will have the same fixed cost towards electricity.
Another example of fixed cost is a website hosting provider which offers unlimited hosting space to its clients at fixed cost. Whether the client puts one or ten websites, and whether the client uses 100 MB or 2 GB of hosting space, the hosting cost remains the same. In these kinds of a scenarios, such electricity and web-hosting cost(s) will not be considered in the contribution margin formula at it represents a fixed cost. Fixed monthly rents or salaries paid to administrative staffs also fall in the fixed cost category.
However, if the same electricity cost increases in proportion to the consumption, and the web-host charges increase on the basis of the number of sites hosted and the space consumed, then the costs will be considered as variable costs. Similarly, wages paid to employees who are getting paid based on the number of units they manufacture (or any of its variations) are variable costs. Each such item will be considered for contribution margin calculations.
Fixed costs are often considered as sunk costs that once spent cannot be recovered. These cost components should not be considered while taking decisions about cost analysis or profitability measures.
Uses of Contribution Margin
Beyond the fixed cost(s), the contribution margin helps determine the selling price range of a product, the profit levels that can be expected from the sales, and structuring the sales commissions paid to sales team members, distributors or commission agents. Contribution margin constitutes the basic block for break-even analysis for overall costing of a product.
The contribution margin measure also helps to select from among the several products that may compete to use the same set of manufacturing resources. Say the pen manufacturing machine is capable of producing both ink pens and ball pens and the business owner or management has to select one of them. If the contribution margin figure of an ink pen is higher than that of a ball pen, the former will be given preference owing to its higher profitability potential on a per unit basis. Such decision making is common to companies which are in the business of manufacturing and marketing a big and diversified portfolio of products and the management has to take a call on allocating the available resources in the most efficient manner to the products with highest profit potential.
Investors and analysts may also attempt to calculate the contribution margin figure for blockbuster products of a company. For instance, a beverage company may have 15 different products but the bulk of company’s profits may come from one of the mint-based drinks. Along with the company management, vigilant investors may keep a close eye on the contribution margin of the mint-based drink relative to the other products to assess the dependency the company has on the star performer. The company steering away its focus from investing or expanding the manufacturing of the star product, or the emergence of a competitor product, may indicate that the profitability of the company and eventually its share price may get impacted.
Very low or negative contribution margin values indicate economically nonviable products whose manufacturing and sales should be discarded. 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.
The concept of contribution margin is applicable at various levels of manufacturing, business segments and products. The figure can be computed for an entire corporate, for a particular subsidiary, for a particular business division or unit, for a particular center or facility, for distribution or sales channel, for product line, or for individual product(s).