Contribution margin definition
/What is the Contribution Margin?
Contribution margin is a product’s price minus all associated variable costs, resulting in the incremental profit earned for each unit sold. The total contribution margin generated by an entity represents the total earnings available to pay for fixed expenses and to generate a profit. A good profit planning technique is to constantly work on improving a firm’s contribution margin, which allows it to generate a profit even when sales levels are declining.
How to Calculate Contribution Margin
To determine the contribution margin, subtract all variable costs of a product from its revenues, and divide by its net revenue. Product variable costs typically include, at a minimum, the costs of direct materials and sales commissions. The calculation is as follows:
(Net product revenue - Product variable costs) ÷ Product revenue = Contribution margin
Contribution Margin Example
The Iverson Drum Company sells drum sets to high schools. In the most recent period, it sold $1,000,000 of drum sets that had related variable costs of $400,000. Iverson had $660,000 of fixed costs during the period, resulting in a loss of $60,000.
| Revenue | $1,000,000 |
| Variable expenses | 400,000 |
| Contribution margin | 600,000 |
| Fixed expenses | 660,000 |
| Net loss | ($60,000) |
Iverson’s contribution margin is 60%, so if it wants to break even, it needs to either reduce its fixed expenses by $60,000 or increase its sales by $100,000 (calculated as $60,000 loss divided by 60% contribution margin).
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How to Use Contribution Margin Analysis
The contribution margin concept can be applied throughout a business, for individual products, product lines, profit centers, subsidiaries, distribution channels, sales by customer, and for an entire business. We note below a variety of situations in which it can be employed to enhance the financial position of a business:
Special pricing situations. The contribution margin concept is useful for deciding whether to allow a lower price in special pricing situations. If the contribution margin at a particular price point is excessively low or negative, it would be unwise to continue selling a product at that price. It is also useful for determining the profits that will arise from various sales levels (see the following example). Some businesses refuse to sell at special price points, on the grounds that they want to maintain their normal retail prices without exception; this is especially common for brands.
Constrained resource situations. The contribution margin concept can be used to decide which of several products to sell if they use a common bottleneck resource, so that the product with the highest contribution margin is given preference. Alternatively, management might increase the price of a product in order to generate a higher contribution margin, thereby justifying its production through the bottleneck. If customers then stop buying the product because of its higher price point, this may be a good indicator that the product has become too commoditized to be worth continuing, and so should be dropped.
Product elimination situations. A key use of the contribution margin concept is in deciding whether to eliminate a product. When a product has a low contribution margin, it is not spinning off much cash, and so should be considered for replacement. An alternative is to raise the price of the product to achieve a more tolerable contribution margin, though this may result in significantly lower sales volume. Some businesses elect to continue selling products that have low contribution margins, on the grounds that they need to offer customers a complete product line; otherwise, customers will switch to the offerings of competitors.
Target costing situations. Contribution margin should be a key component of the target costing process, where a required margin is established before a product is designed. The product design process then goes through several iterations, to see if the projected price and cost of the product will result in the minimum desired contribution margin. If not, the product design project is abandoned. This usually means that the concept is put on hold and is re-evaluated from time to time, to see if the circumstances have changed sufficiently to justify restarting the product development process.
Limitations of Contribution Margin Analysis
When using this measurement, be aware that the contribution margin does not account for the impact of a product on the bottleneck operation of a company. A low contribution margin may be entirely acceptable, as long as it requires little or no processing time by the bottleneck operation. In this case, a business is still generating some incremental margin, which contributes to the total profit of the business without impacting its bottleneck operation.
Fixed Costs vs. Variable Costs
An essential concept when dealing with contribution margins is whether a cost is fixed or variable. A fixed cost is any cost that is incurred in the same amount, irrespective of changes in transaction volume. For example, the monthly rent payment is considered a fixed cost, because it must be paid in the same amount, even if a business is generating no sales at all. Conversely, a variable cost is any cost that changes in accordance with transaction volume. For example, a commission is only paid when there is a sale, and merchandise costs are not incurred unless there is a sale. There are also mixed costs, such as a monthly base charge for maintaining a bank account, plus additional fees for bounced checks, cashed checks, and so forth. When a business incurs mixed costs, the accountant must determine which portion is fixed and which is variable, so that the variable portion can be included in the contribution margin calculation.
Contribution Margin vs. Gross Profit Margin
Contribution margin is a product’s price, minus all related variable costs. This differs from the gross profit margin, which is a product’s price, minus the associated cost of goods sold. The cost of goods is the differentiating factor between the two concepts, because it includes not just variable costs, but also any related production overhead costs. In addition, the contribution margin calculation includes sales commissions, which are not usually included in the cost of goods sold.
The gross profit margin is much more commonly used in the presentation of an income statement, and so is the figure most people see when they peruse an income statement. You would need to restructure such an income statement in order to determine the contribution margin.
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