What Is the Contribution Margin?
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 Formula for Contribution Margin Is
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 revenue−Variable costs
The above formula is also used as a ratio, to arrive at an answer in percentage terms, as follows:
Contribution margin ratio=Sales revenueSales Revenue−Variable costs
What Does the Contribution Margin 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 Versus 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 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 a 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 scenarios, 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.
- 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.
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 assess how much profits can be realized by scaling up sales.
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.
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.
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 a product line, or for individual products.