What Is the Contribution Margin?
Facts and Formulas
The contribution margin is the sales price of a unit, minus the variable costs involved in the unit's production. It is used to find an optimal price point for a product.
It also measures whether the product is generating enough revenue to pay for fixed costs and determine the profit it is generating. The contribution margin can be calculated in dollars, units, or a percentage.
Additionally, the contribution margin is used to determine the break-even point, which is the number of units produced or revenues generated to break even.
Elements of the Contribution Margin
To understand the contribution margin, you'll need to familiarize yourself with the financial terms included in the calculation.
A company's variable expenses include costs that fluctuate along with changes in production levels. Some examples of variable costs are raw materials, direct labor, and electricity.
Fixed expenses are the costs that are consistent. These expenses can fluctuate, but for the most part, they stay the same. Examples of fixed costs include building rent, insurance, salaries, and utilities (that are not directly related to production).
Calculating the Contribution Margin
You can calculate the contribution margin by using the following equation:
Contribution Margin = (Net Product Revenue - Product Variable Costs) ÷ Product Revenue
Sometimes it's useful to put the answer in terms of units, to understand how much profit one unit generates. The contribution margin per unit is calculated as:
Contribution Margin per Unit = (Revenue - Variable Expenses) ÷ Total Units
The contribution margin is the difference between sales and variable costs. The amount that's leftover is the combination of fixed expenses and profit.
Contribution Margin Ratio
The contribution margin ratio is the percentage of difference in a company's sales and variable expenses. Variable expenses are subtracted from sales to isolate profit and fixed expenses. This ratio then explains in percentage form the amount of revenue that is profit and fixed expenses.
Contribution Margin Ratio = (Sales - Variable Expenses) ÷ Sales
The break-even point is one of the purposes for calculating your contribution margin. It exhibits the point at which a company covers fixed expenses and generates no profit.
Break-Even Point = Total Fixed Expenses ÷ Contribution Margin Ratio
You can calculate your break-even point in units to determine the amount you must sell to break even. This method uses total fixed expenses (for your products) and the average contribution margin per unit. Calculate your average contribution margin per unit using the formula:
Average Contribution Margin per Unit = (All Sales - All Variable Expenses) ÷ Number of Units Sold
Then calculate your break-even point in units:
Break-Even Point in Units = Total Fixed Expenses ÷ Average Contribution Margin Per Unit
The break-even point can be used with other methods of analysis. Performing a cost analysis of your fixed and variable costs at regular intervals can help to determine where you could make changes if needed.
For example, a cost analysis of fixed expenses could reveal a high amount of fixed costs. You could then investigate ways to reduce your fixed expenses.
Analyzing a product's contribution margin and break-even point provides information on the company's operational efficiency. These two measurements also give business owners information on pricing. Once you know the profit (or loss) a product is generating, you can begin to analyze and adjust prices accordingly.