How to calculate contribution margin
/What is Contribution Margin?
Contribution margin is the revenue from a sale transaction, less all variable costs associated with that sale. The resulting margin represents the amount of cash that is available to pay fixed costs and earn a profit. A high contribution margin implies that a business will probably be able to generate a reasonable profit even if sales decline by a substantial amount. Conversely, a low contribution margin implies that a business may not be able to survive a serious downturn in its sales.
Uses of Contribution Margin
The contribution margin concept is frequently used to establish the lowest price at which a product or service can be sold in incremental unit pricing situations. However, a variety of other pricing concepts can be used to establish higher price points for products. Another use is in deciding which products to manufacture or sell; when management does not have sufficient resources to produce all possible products (perhaps due to a bottleneck), it should strongly consider producing those with the highest contribution margin, which will result in the greatest possible profit generated from the available resources.
How to Calculate Contribution Margin
The steps to follow to calculate contribution margin for a specific sale transaction are as follows:
Net the gross sales amount against any deductions, such as for sales allowances, to arrive at the net revenue figure.
Aggregate all variable costs associated with the sale. Examples of these costs are the direct materials, direct labor, shipping cost, and commission associated with the product sold. If the transaction was for services instead of sales, then the variable costs are likely to be the labor associated with the sale, plus related payroll taxes and any benefits that vary with hours worked.
Subtract the aggregated variable costs from the net revenue figure.
If you want to derive the contribution margin ratio, then divide the contribution margin into the net sales figure.
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How to Improve Contribution Margin
Once a contribution margin has been calculated, it makes sense to work on improving the margin over time. Doing so results in an ongoing increase in profitability. There are several options for doing so. For example, a business could make volume purchases in order to acquire direct materials with volume discounts. Another option is to alter product configurations in order to use less-expensive materials. Or, products could be redesigned to require less manufacturing labor to produce. Yet another option is to move production to a low-cost region, which reduces labor costs.
Example of Contribution Margin
ABC International completes a sale transaction for which the gross sale amount is $100,000, and to which a volume discount of $8,000 applies, resulting in a net sale of $92,000. The transaction is for a product sale, where the direct cost of the product is $50,000. The salesman who completed the deal will receive a $2,000 commission, so the aggregated amount of all variable costs is $42,000. Based on this information, the contribution margin is:
$92,000 Net revenue - $52,000 Variable expenses = $40,000 Contribution margin