Contribution Margin
The leftover sales revenue of a product once you deduct the variable costs of producing and selling that particular product
What is Contribution Margin?
Contribution Margin is the remaining sales revenue from a product after subtracting the variable costs associated with its production and sale.
This excess revenue is often used to cover the fixed costs of the business. After covering fixed costs, if there is still any revenue left, it is considered profit for the business.
It is also known as the dollar contribution per unit or marginal profit per unit sale and can be expressed as a gross amount, amount per unit, or even as a percentage of net sales.
Key Takeaways
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Contribution margin is the leftover revenue from sales after subtracting the variable costs associated with producing and selling a product. It is a critical financial metric for understanding how much revenue is available to cover fixed costs and contribute to profits.
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Contribution margin helps businesses assess their ability to cover fixed costs, and any remaining margin represents profit. It is a valuable tool for decision-making, pricing strategies, and product profitability analysis.
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Fixed costs remain constant and are not dependent on production or sales levels, while variable costs fluctuate with changes in production or sales volume. Understanding the balance between these cost types is crucial for managing contribution margins effectively.
Formula for Contribution Margin
There are a couple of different ways you can calculate contribution margin. The most commonly used formula is:
Contribution Margin = Total Sales Revenue (TSR) - Total Variable Cost (TVC)
With this formula, the unit contribution margin can be calculated by inputting the revenue and variable costs for one unit of a product.
This formula can also be applied to a product line by using the total revenue and variable costs associated with the sales of a particular product.
But what if the variable costs cannot be properly identified? In that case, you may be able to use the following formula:
Contribution Margin = Fixed Costs + Net Income
If you recall, the contribution margin is used to cover fixed costs; anything remaining is considered profit or net income.
This can be represented as:
Contribution Margin - Fixed Costs = Net Income
Therefore, adding fixed costs and net income would be another way to come up with the contribution margin.
It can also be calculated as a ratio or percentage of the total sales revenue:
Contribution Margin Percentage = TSR - TVC / TSR x 100
This can be particularly useful in comparing different products and understanding how profitable a certain product may be relative to another.
To accurately utilize these formulas, it is important to comprehend the differences between fixed and variable costs.
Fixed costs Vs. Variable Costs
Fixed costs are business expenses that do not change regardless of changes that may occur in production or sales. These costs are independent of the business operations and are often considered sunk costs because they cannot be recovered once spent.
Some common examples of fixed costs are rent, administrative salaries, depreciation, or utility expenses.
Variable costs are expenses that vary depending on the number of units produced or the quantity sold of a product. Variable costs can rise if the level of production increases, just as they can decrease if production falls.
A few examples of these costs include direct material expenses, sales commissions, and wages paid per unit produced. If a business has a sizeable amount of variable costs compared to its fixed costs, it usually means the business can function with a low contribution margin.
On the contrary, if the business has high fixed costs relative to its variable costs, it would need a higher contribution margin to be able to pay its fixed expenses.
Contribution Margin calculation
Suppose a shoe company buys a new machine to manufacture their shoes faster at the expense of $20,000. The raw materials needed to make the shoes, such as cloth, plastic, and rubber, cost $5 for every pair of shoes.
Every pair of shoes manufactured also costs the company $4 in labor charges and another $1 per pair to transport the shoes from the factory to their stores. The shoe company sells its popular shoes for a price of $100 per pair, and they produced and sold 1,000 pairs.
The first step here is to differentiate between fixed and variable expenses.
In this example, the $20,000 spent to purchase the machine can be considered a fixed cost because it would not change whether the company sold 100 pairs or 1,000 pairs.
Even if the company temporarily shut down and sold no shoes, they would still have to pay the $20,000. That being so, the $20,000 would not be used to calculate the contribution margin.
The cost of the raw materials, labor expenses, and transportation expenses are all given as a price per pair.
Therefore, the number of units sold would affect the total expenses of the company, which is why these costs are variable costs.
Adding up the variable costs per unit: $5 + $4 + $1, the total variable cost (TVC) per unit would come out to $10.
Multiplying the TVC per unit by the total number of units manufactured would give us the total variable cost.
TVC = $10 x 1,000 units = $10,000
Similarly, multiplying the sales price per shoe and the units sold would be the total sales revenue (TSR)
TSR = $100 x 1,000 units = $100,000
Now we can calculate the Contribution Margin using the formula given earlier:
Contribution Margin = TSR - TVC
= $100,000 - $10,000 = $90,000
It can also be represented as an amount per unit by using the total variable costs and total sales revenue of an individual unit. In this instance that would be:
Contribution Margin = (TSR / unit) - (TVC / unit)
= $100 - $10 = $90 per unit
It is important to make sure the dollar amounts you use for the TSR and TVC are for the same number of units, otherwise, your answer may be inaccurate.
For example, subtracting the TVC/unit from the TSR would be incorrect as they are values for a different number of units.
Another way to calculate the contribution margin here is as a percentage of the sales revenue using the formula:
(TSR - TVC) / TSR
= ($100,000 - $10,000) / $100,000 * 100 = 90%
This insinuates that 90% of the revenue from these shoes can be used to pay for the new machine and potentially translate to earnings, and only 10% of it will be lost while acquiring the revenue.
We can even take a step further and subtract the total fixed costs from the contribution margin to determine the net income.
Contribution Margin - Fixed Costs = Net Income
= $90,000 - $20,000 = $70,000
How Important is Contribution Margin in Business?
It could provide information on how efficiently the business is pricing its products. If a particular product has a low contribution margin, then perhaps the product is priced too low, and prices could be raised to earn more profit.
On the contrary, suppose a business is selling a product at a price that is considered the norm among its competitors. However, the business has a much lower contribution margin than its competitors.
In this case, the business would have to take a look at its variable costs and see if any changes could be made to cut costs and increase the marginal profit per unit of sale.
The business might decide to switch to a cheaper supplier for their raw materials or even consider cutting the pay of workers to reduce the labor cost per unit made.
Businesses that sell many different products can also use the contribution margin to understand which of their different products are the most profitable. Managers might decide to cut certain product lines if they produce a low marginal profit per unit sold.
On the other hand, managers could add new product lines if they have a high marginal profit per unit sold. Sometimes a business can have limited resources to use for their different products.
Usually, the products with the higher contribution margin will be allocated more resources because they will produce greater profits than if the same resources were used for the lower contribution margin product.
Taking this into consideration, a higher contribution margin is more desirable than a lower. A negative contribution margin indicates that producing a product is losing the business more money than they earn selling it.
It is also used by managers to determine how many units must be sold for the business to break even or have a net profit of zero. This is the point at which the total revenue for a product equals total expense, otherwise known as the break-even point.
The break-even point is calculated by the following formula:
Break Even Point = Total Fixed Costs / Contribution Margin
This formula assumes that variable costs are constant per unit of production.
Contribution Margin and Investors
Investors use many different indicators and thoroughly examine a company’s financials before deciding to invest in a company. The contribution margin of a company’s product lines is one particular factor investors may look at when researching a company.
For example, suppose Company A offers ten products, but most of its revenue comes from one product. Company B offers five products, but its revenue is almost equally distributed around these different products.
Company A could be riskier to invest in because if the demand for its best-selling product slows down, or perhaps a fire occurs in the factory that produces it, there would be a significant impact on the company’s profits and the share price as well.
On the other hand, if one of Company B’s products experienced a similar situation, its profits would be impacted less because the other products could continue to do well and make up for the poor performance of one product.
Company B will have reduced their risk for the unpredictable by earning profits more equally spread out over different products. Investors would most likely prefer to invest in Company B because there is less risk associated with the company’s business strategy.
Misinterpreting Contribution Margin
There are many different ways mistakes can be made when using the contribution margin. Sometimes it can be difficult to differentiate whether an expense is a fixed cost or variable cost.
For example, suppose a company hires ten extra workers, just for two months, to increase the production of a product during a period of high demand.
This can be considered a fixed cost since it is only temporary, and the amount of units produced does not change the cost of hiring the workers.
However, it can also be considered a variable cost because the increased number of units that needed to be produced had a direct impact on the decision to hire temporary workers.
Allocating the expense of the temporary workers as either a fixed or variable cost would change the value of the contribution margin.
Another mistake could be made only by looking at the contribution margin when deciding to stop producing a certain product line.
A product could have an unattractive contribution margin, but perhaps there are currently very few competitors for this product, or there could be barriers to entry limiting future competitors from entering this market.
In these situations, it would be beneficial to keep the product line. The product may also provide very steady profits and require very little investment to keep selling.
Although the contribution margin may not be too high, it could be strategic to keep these products in your business.
Contribution margin vs. Gross profit margin
Although they both concentrate on distinct facets of a company's financial performance, contribution margin and gross profit margin are financial indicators used to assess a company's profitability.
The Contribution Margin and Gross Profit Margin are contrasted below:
| Aspect | Gross Profit Margin | Contribution Margin |
|---|---|---|
| Definition | Percentage of total revenue remaining after deducting COGS. | Profitability of a specific product or product line by calculating the difference between total revenue and variable costs. |
| Calculation | (Total Revenue - COGS) / Total Revenue | Total Revenue - Total Variable Costs |
| Inclusions | Includes only the direct production costs (COGS). | Considers variable costs, such as materials and labor, directly tied to the production of a specific product. |
| Purpose | Assesses how efficiently a business generates revenue compared to the costs of producing or purchasing goods. | Used to evaluate the profitability of individual products or product lines, aiding pricing and production decisions. |
| Applicability | Applicable at the business level, providing an overview of overall profitability. | Applied to assess profitability at a granular level, focusing on specific products or product lines within the business. |
| Flexibility | Provides a general overview of a company's overall profitability. | Offers a more detailed and product-specific perspective on profitability. |
As a useful statistic for decision-making across a variety of sectors and business structures, contribution margin offers a more complete view of a company's financial health by taking a wider range of costs into consideration.
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