Here’s a look at what contribution margin is, how it is calculated, and why it is a useful measure that helps businesses understand their costs and profit potential.
Definition and Examples of Contribution Margin
To understand what contribution margin is you first need to have a basic understanding of how businesses define their costs. Businesses classify the costs of producing products and providing services into two basic categories: fixed and variable. Fixed costs do not change with the level of production, while variable costs do. Contribution margin is the revenue that is generated beyond what is necessary to cover the variable costs of production, such as materials and non-salaried labor costs. This excess revenue is what is available to cover the fixed costs. It can also include the firm’s profit if the amount exceeds the total amount of the fixed costs.
Unit Contribution Margin vs. Total Contribution Margin
You can calculate the contribution margin for individual products, called unit contribution margin, or for the entire business, which is called total or gross contribution margin. To calculate the unit contribution margin, you subtract the variable costs per unit from the selling price per unit. Unit Contribution Margin = Price - Variable Unit Cost For example, if the price of a bottled drink is $1.50 and the variable costs of the materials, labor, and overhead for that one bottled drink were $1, then the unit contribution margin is 50 cents. This tells you that each bottled drink the company produces and sells contributes 50 cents toward covering fixed costs and generating a profit. Total contribution margin measures the same thing but at the aggregate level so it is done with total values rather than unit values. The formula for total contribution margin is sales (or revenue) minus the total variable cost: Total Contribution Margin = Sales - Total Variable Cost For example, suppose your company manufactures and sells 1 million bottles of a drink, each at $1.50 with $1 in variable costs. Sales equals 1 million bottles multiplied by $1.50 each, which comes to $1.5 million. Total variable cost equals $1 per bottle multiplied by the 1 million bottles, which comes to $1 million. The total or gross contribution margin is $1.5 million minus $1 million, which equals $500,000. You can check that total contribution margin and unit contribution margin measure the same thing just at different levels by comparing them in this example. The $500,000 in total contribution margin is the same as 1 million bottles multiplied by the unit contribution margin of 50 cents (50 cents x $1 million = $500,000).
How Contribution Margin Works
Contribution margin is a tool of cost-volume-profit (CVP) analysis that helps businesses assess how costs, sales volume, and price affect operating profitability. The equation for determining operating profit is: Operating Profit (or Income) = Sales - Total Variable Cost - Total Fixed Cost By looking at the operating profit in this way, a business can examine how changes in sales, variable costs, and fixed costs impact operating profit. Now, it’s important to remember that costs are divided into two broad categories: fixed and variable. Variable costs are subtracted from sales to arrive at the contribution margin. The next step after finding the contribution margin would then be to subtract fixed costs. That equation can be seen as: Operating Profit = Contribution Margin - Total Fixed Expenses To see an example of how a firm can use the contribution margin in analyzing operating profit let’s continue to use the bottled drink example from above. Assume your drink bottling business has $300,000 in fixed costs, which are costs that do not vary with the level of production. Common examples of fixed costs include salaried employees, lease or rent payments, and insurance premiums. Your contribution margin is $500,000. You subtract the $300,000 in fixed costs to get $200,000 in operating profit. Since your total contribution margin is $500,000 (which is what you get when you subtract variable costs from sales), you can see that you have generated enough revenue to cover both fixed and variable costs of production and generate an operating profit of $200,000.
Finding the Break-Even Point
The contribution margin can be used to quickly see the number of units a firm needs to produce and sell in order to break even. The break-even point (BEP) is when a business recoups the cost of offering that product or service. To find the number of units required to break even, simply divide the firm’s total fixed costs by the unit contribution margin. This lets managers and business owners know the level of sales required to cover all costs and begin earning a profit. In our bottled drink example, the break-even point of units is 600,000 bottles ($300,000 / 50 cents). At 600,000 bottles, we generate enough revenue to exactly cover operating costs. We would operate at a loss if we sell fewer bottles and earn a profit if we sell more.
Targeting Profit
The contribution margin can also be used to quickly determine the number of units a firm needs to sell to achieve a target operating profit. The formula for this is similar to the formula for determining the break-even point, but with the addition of the desired income: (Fixed Costs + Target Income) / Unit Contribution Margin = Total Units Required For our drink example, let’s assume that we have a goal of generating $1 million in target income. To determine the number of bottles we need to sell to do that we add the fixed costs of $300,000 to the $1 million target income for a total of $1.3 million. We then divide that by the unit contribution margin of 50 cents: ($300,000 + $1 million) / 50 cents = 2.6 million bottles. We would need to sell 2.6 million bottles to reach our target operating profit of $1 million.
Contribution Margin vs. Contribution Margin Ratio
The contribution margin can be expressed as the number of dollars as we have seen, but it can also be presented as a percentage. Expressing the contribution margin as a percentage is called the contribution margin ratio. This is the percentage of revenue remaining after the variable costs have been covered. It can be calculated using either the unit contribution margin or the total contribution margin. At the unit level, it is calculated as the unit contribution margin divided by the unit price. From our bottled drink example we can calculate it as 50 cents / $1.50 = .33 or 33%. Using total contribution margin we would divide the $500,000 total contribution margin by the total sales of $1.5 million for $500,000 / $1.5 million = .33 or 33%. Again, it’s not a coincidence that we get the same ratio because it measures the same information just at different levels.
