What Is the Contribution Margin?
Facts and Examples of Contribution Margin
The contribution margin is a concept used to interpret different kinds of financial statement data, such as with a breakeven point or break-even analysis. The contribution margin represents the amount of money a company has to cover its fixed costs after it pays all of its variable expenses. It also includes the amount, if any, left over after covering fixed costs that constitute the company's net operating profit or net operating loss.
A company's variable expenses include costs that fluctuate along with changes in production levels. This includes raw materials, direct labor, and electricity, for example. Fixed expenses are the costs that need to be covered even if a company doesn't produce any units of product. Examples of fixed costs include building rent. insurance, and property tax.
Calculating the Contribution Margin
You can calculate the contribution margin by using the following equation:
Contribution Margin = Sales Revenue - Variable Expenses
Sometimes it's useful to put the answer in terms of units, to understand how much one unit of the product contributes to a company's profit, or bottom line. The contribution margin per unit is calculated as:
Contribution Margin per unit of sales = Sales Revenue per Unit - Variable Expenses per Unit
Since the contribution margin takes the difference between sales and variable costs, the piece that's left over is the combination of fixed expenses and profit.
To isolate just the remaining profit, use the following equation:
Contribution Margin - Fixed Costs = Net Operating Profit or Loss
Analyzing a company's contribution margin provides information on the company's operational effectiveness. A business generating higher profits on its products relative to its fixed and variable expenses, as compared to its competitors, has a good operational and competitive advantage.
Using the Break-Even Formula
The break-even formula calculates the point at which a company's sales just cover its expenses, and there is no profit or loss. It's important for companies to know their break-even point because it represents the minimum number of units they need to sell to stay in business. It's the same thing as the contribution margin with no profit component.
The denominator of the break-even equation is the contribution margin. As an example, imagine a company that has fixed costs of $60,000, a product price of $2.00 per unit and variable costs of 80 cents per unit. The following example illustrates how to find the minimum number of units the XYZ Corporation needs to break even:
Break-even in Units = Total Fixed Costs / Contribution Margin per unit
Breakeven point = $60,000 / ($2.00 - $0.80) = 50,000 units
The contribution margin, in this case, is $1.20 per unit ($2.00 - $0.80). XYZ Corporation has to produce and sell 50,000 units of its products just to cover its total expenses, fixed and variable. At this level of sales, the company will make no profit but will just break-even with a contribution margin of $1.20 per unit sold or $60,000 (50,000 X $1.20).
Gross Margin vs Contribution Margin
It is important for a financial manager to know that, on the income statement, the gross profit margin and the contribution margin are not the same.
The gross profit margin calculation, often shown on a company's income statement, is the difference between sales and cost of goods sold. Contrary to the contribution margin, the cost of goods sold includes all costs, both fixed and variable. The contribution margin is the difference between sales and variable costs only. Calculating both can give the financial manager valuable, but different, information.
Contribution Margin Ratio
The contribution margin ratio is the contribution margin, set as a percentage of total sales. In this formula, you'll use the total contribution margin, not the unit contribution margin. Calculating this ratio is important for the financial manager as it addresses the profit potential of the firm. Calculate the ratio as follows:
Contribution margin ratio = Contribution margin / sales
ABC Corp. Contribution margin ratio: ($40,000 contribution margin / $100,000 sales) = .40, or 40 percent.
This means that for every dollar increase in sales, there will be a 40 cent increase in the contribution margin to cover fixed costs.