Contribution Margin

Definition

The contribution margin (CM) is the difference between the selling price of a unit and variable cost per unit or the difference between a firm’s revenue and its total variable costs. In other words, it’s a proportion of revenue available to cover fixed costs of a firm.

 

Formula

The contribution margin can be expressed in the following ways: per unit, in total, and as a ratio.

The per unit formula can be represented as follows:

CM Per Unit = P – VC

where P is the selling price of a unit, and VC is the variable cost per unit.

The total contribution margin (CMTotal) of a firm can be calculated as follows:

CM Total = Total Sales – Total Variable Costs

Graphically, it can be represented as follows:

contribution-margin-c

The contribution margin ratio (CMRatio) can be calculated as follows:

contribution-margin-ratio

 

Contribution margin analysis

The goals of contribution margin analysis are as follows:

  1. Studying the possibility of lowering a product’s price in special situations.
  2. Determining how the change in price affects the break-even point and operating profit or loss.

contribution-margin-analysis-c

For example, a decrease in the selling price will lead to a lower total contribution margin and will shift the break-even point to a higher volume. The concept is also a useful tool in determining the operating profit or loss at various levels of selling prices and sales volumes.

 

Gross margin

Do not confuse contribution margin with gross margin! The first appears in a statement of income if a firm applies variable costs. Such an approach implies two groups of cost: fixed costs and variable costs.

In contrast, gross margin appears in a statement of income if a firm uses absorption cost. In such a case, all costs are classified into two groups: period costs and product costs. In turn, product costs include direct labor costs, direct materials, and overhead. So, gross margin is the difference between a firm’s total sales and the cost of goods sold (COGS).

 

Example

Let’s assume Company A is currently producing and selling just one product at a selling price of $150 per unit. Variable costs per unit are $90, and annual fixed costs are $750,000. During the financial year, Company A sold 14,750 units.

Thus, the CM per unit is $60.

CM Per Unit = 150-90 = $60

The total CM will be $885,000.

CM Total = 14,750*150 -14,750-90 = $885,000

The CM ratio of Company A will be 40%.

CM-1

The total contribution margin of $885,000 allows Company A to cover all fixed costs of $750,000 and have an operating profit of $135,000.