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.
What Is the Contribution Margin?
The contribution margin is the amount of money a business has to cover its fixed costs and contribute to net profit or loss after paying variable costs. It also measures whether a product is generating enough revenue to pay for fixed costs and determines the profit it is generating. The contribution margin can be calculated in dollars, units, or as 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. It also lets you know how much a particular product is contributing to your overall business profit.
How Do You Calculate 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).
You can calculate the contribution margin by using the following equation:
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:
The contribution margin is the difference between sales and variable costs. The amount that's left over is the combination of fixed expenses and profit. So if the price of your product is $25 and the unit variable cost is $5, the unit's contribution margin is $20.
How Is the Contribution Margin Ratio Different?
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:
How the Contribution Margin Works
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.
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:
Then calculate your break-even point in units:
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.
It's also a way to help structure sales commissions or decide which products to keep in your product line and which ones to remove. You can apply your company's resources to those products with the best contribution margins.
Limitations of Contribution Margins
If expenses are classified as fixed when they are actually variable, it can cause a misleading contribution margin calculation and result in a poor business decision. Also, products with a low contribution margin that sell in high volume with no required effort would be worth keeping in the company's product line.
- A contribution margin is the sales price of a unit, minus the fixed and variable costs involved in the unit's production.
- It allows you to calculate the break-even point.
- This permits you to find an optimal price point for a product.
- Analyzing the fixed and variable costs also allows you to adjust them.