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.
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:
The contribution margin ratio (CMRatio) can be calculated as follows:
Contribution margin analysis
The goals of contribution margin analysis are as follows:
- Studying the possibility of lowering a product’s price in special situations.
- Determining how the change in price affects the break-even point and operating profit or loss.
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.
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).
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%.
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.