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Contribution margin is a cost accounting concept that lets a company determine the profitability of its individual products. The phrase "contribution margin" can also refer to a per unit measure of a product's gross operating margin. It's calculated as the product's sale price minus its total variable costs per unit. This metric helps a company evaluate different areas of the business to determine the profitability of each service or product.

Contribution margin is the sales price minus total variable costs, where variable costs might include materials, labor or overhead. For example, Company XYZ sells a product for $100 each. The company incurs a unit variable direct material expense of $12, unit variable labor expense of $25, $10 of variable overhead per unit and $8 of fixed overhead per unit.

The contribution margin for our example is:

Contribution Margin ($53) = Sales Price ($100) - Variable Direct Materials ($12) - Variable Labor ($25) - Variable Overhead ($10)

Note that the $8 in fixed overhead per unit is not included, because fixed costs are not considered when calculating contribution margin.

Usefulness of Contribution Margin

Contribution margin is used by management when making pricing decisions. This is especially true in special pricing or special order situations where fixed costs are sunk costs and should not be factored into the decision whether to accept or reject. Negative or low contribution margins indicate a product line or business segment may not be profitable. In addition, the contribution margin is helpful to analyze the impact of different levels of sales. Finally, a business can use contribution margin to resolve bottlenecks. If limited resources are available, a business wants to use its scarce resources for the most profitable items. Therefore, constraints are eliminated by awarding the most profitable items of resources.

Contribution Margin Ratio

Contribution margin is directly related to the contribution margin ratio. The contribution margin ratio can be calculated on a per-unit basis or an aggregate basis. The per-unit basis divides the contribution margin per unit by the unit sale price, while the total contribution margin ratio divides the total contribution margin by the total revenue. The figure will result in a percentage that indicates what percentage of each dollar of revenue is generated to cover fixed costs. 

Break-even or Target Income Analysis

The contribution margin is an integral aspect when calculating the break-even point of sales or a target level of sales. The contribution margin determines the portion of each sale that is attributed to covering fixed costs. For this reason, fixed costs divided by the contribution margin results in the number of units needed to be sold to break-even. To find a target net income, the target amount is added to total fixed costs.

In our example above for Company XYZ, the break-even point is just over 15 units. The calculation would be: Fixed Overhead Per Unit ($8) / Contribution Margin Ratio of 53% ($53 / $100). 

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