What Is Contribution Margin?
The contribution margin can be stated on a gross or per-unit basis. It represents the incremental money generated for each product/unit sold after deducting the variable portion of the firm's costs.
The contribution margin is computed as the selling price per unit, minus the variable cost per unit. Also known as dollar contribution per unit, the measure indicates how a particular product contributes to the overall profit of the company.
It provides one way to show the profit potential of a particular product offered by a company and shows the portion of sales that helps to cover the company's fixed costs. Any remaining revenue left after covering fixed costs is the profit generated.
- The contribution margin represents the portion of a product's sales revenue that isn't used up by variable costs, and so contributes to covering the company's fixed costs.
- The concept of contribution margin is one of the fundamental keys in break-even analysis.
- Low contribution margins are present in labor-intensive companies with few fixed expenses, while capital-intensive, industrial companies have higher fixed costs and thus, higher contribution margins.
Formula and Calculation of Contribution Margin
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. This is expressed through the following formula:
Where C is the contribution margin, R is the total revenue, and V represents variable costs.
It may also be useful to express the contribution margin as a fraction of total revenue. In this case, the Contribution Margin Ratio (CR) is expressed as the contribution margin, divided by total revenues in the same time period:
What Contribution Margin Can Tell You
The contribution margin is the foundation for break-even analysis used in the overall cost and sales price planning for products. The contribution margin helps to separate out the fixed cost and profit components coming from product sales and can be used to determine the selling price range of a product, the profit levels that can be expected from the sales, and structure sales commissions paid to sales team members, distributors, or commission agents.
Fixed Cost vs. Variable Cost
One-time costs for items such as machinery are a typical example of a fixed cost that stays the same regardless of the number of units sold, although it becomes a smaller percentage of each unit's cost as the number of units sold increases.
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 the government offers unlimited electricity at a fixed monthly cost of $100, then manufacturing 10 units or 10,000 units will have the same fixed cost towards electricity.
In these kinds of scenarios, electricity will not be considered in the contribution margin formula as it represents a fixed cost. However, if the electricity cost increases in proportion to consumption, it will be considered a variable cost.
Fixed costs are often considered sunk costs that once spent cannot be recovered. These cost components should not be considered while taking decisions about cost analysis or profitability measures.
Contribution Margin vs. Gross Profit Margin
The contribution margin is different from the gross profit margin, the difference between sales revenue and the cost of goods sold. While contribution margins only count the variable costs, the gross profit margin includes all of the costs that a company incurs in order to make sales.
The contribution margin shows how much additional revenue is generated by making each additional unit product after the company has reached the breakeven point. In other words, it measures how much money each additional sale "contributes" to the company's total profits.
Example of Contribution Margin
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 manufactured, 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, ink pen production will be impossible without the manufacturing machine which comes at a fixed cost of $10,000. This cost of the 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
(SP−TC)=($2.0−$1.6)=$0.4 per Unitwhere:SP=Sales priceTC=Total costs
However, the 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:
(SP−TVC)=($2.0−$0.6)=$1.4 per Unitwhere:SP=Sales priceTVC=Total variable costs
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.
Uses of Contribution Margin
The contribution margin can help company management select from among several possible products that compete to use the same set of manufacturing resources. Say that a company has a pen-manufacturing machine that is capable of producing both ink pens and ball-point pens, and management must make a choice to produce only one of them.
If the contribution margin for an ink pen is higher than that of a ball pen, the former will be given production preference owing to its higher profitability potential. Such decision-making is common to companies that manufacture a diversified portfolio of products, and management must allocate available resources in the most efficient manner to products with the highest profit potential.
Contribution Margin for Investors
Investors and analysts may also attempt to calculate the contribution margin figure for a company's blockbuster products. For instance, a beverage company may have 15 different products but the bulk of its profits may come from one specific beverage.
Along with the company management, vigilant investors may keep a close eye on the contribution margin of a high-performing product relative to other products in order to assess the company's dependence on its star performer.
The company steering its focus away 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.
How to Improve Contribution Margin
Based on the contribution margin formula, there are two ways for a company to increase its contribution margins; They can find ways to increase revenues, or they can reduce their variable costs.
Variable costs tend to represent expenses such as materials, shipping, and marketing, Companies can reduce these costs by identifying alternatives, such as using cheaper materials or alternative shipping providers.
Alternatively, the company can also try finding ways to improve revenues. For example, they can increase advertising to reach more customers, or they can simply increase the costs of their products. However, these strategies could ultimately backfire and result in even lower contribution margins.
When to Use Contribution Margin Analysis
Investors examine contribution margins to determine if a company is using its revenue effectively. A high contribution margin indicates that a company tends to bring in more money than it spends.
Very low or negative contribution margin values indicate economically nonviable products whose manufacturing and sales eat up a large portion of the revenues.
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 corporation, for a particular subsidiary, for a particular business division or unit, for a particular center or facility, for distribution or sales channel, for a product line, or for individual products.
How Do You Calculate Contribution Margin?
Contribution margin is calculated as Revenue - Variable Costs. The contribution margin ratio is calculated as (Revenue - Variable Costs) / Revenue.
What Is a Good Contribution Margin?
The best contribution margin is 100%, so the closer the contribution margin is to 100%, the better. The higher the number, the better a company is at covering its overhead costs with money on hand.
What Is the Difference Between Contribution Margin and Profit Margin?
Profit margin is the amount of revenue that remains after the direct production costs are subtracted. Contribution margin is a measure of the profitability of each individual product that a business sells.
The Bottom Line
The contribution margin represents the revenue that a company gains by selling each additional unit of a product or good. This is one of several metrics that companies and investors use to make data-driven decisions about their business. As with other figures, it is important to consider contribution margins in relation to other metrics rather than in isolation.