 # Contribution Margin By Yuriy Smirnov Ph.D.

## 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 (CM Total) 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 (CM Ratio) can be calculated as follows:

 CM Ratio = Contribution Margin per Unit = Total Contribution Margin Selling price of a Unit Total Sales

## 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. 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 Ratio = \$60 = \$885,000 = 40% \$150 14,750 × \$150

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.