Contribution Margin

The 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 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. This is expressed through the following formula: C=R−V

Where C is the contribution margin, R is the total revenue, and V represents variable costs.

It may also be useful to express the contribution margin as a fraction of total revenue. In this case, the Contribution Margin Ratio (CR) is expressed as the contribution margin, divided by total revenues in the same time period: CR= R (R−V)

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.

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 10 units or 10,000 units will have the same fixed cost towards electricity.

In these kinds of scenarios, electricity will not be considered in the contribution margin formula as it represents a fixed cost. However, if the electricity cost increases in proportion to consumption, it will be considered a variable cost. Fixed costs are often considered sunk costs that once spent cannot be recovered. These cost components should not be considered while taking decisions about cost analysis or profitability measures.

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