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How To Calculate Contribution Margin
How To Calculate Contribution Margin
The contribution margin is computed as the selling price per unit, minus the
variable cost per unit. Also known as dollar contribution per unit, the measure
indicates how a particular product contributes to the overall profit of the
company.
It provides one way to show the profit potential of a particular product offered
by a company and shows the portion of sales that helps to cover the company's
fixed costs. Any remaining revenue left after covering fixed costs is the profit
generated.
The contribution margin is computed as the difference between the sale price of
a product and the variable costs associated with its production and sales
process. This is expressed through the following formula:
V
C=R−V
CR
(R
V)
CR=
(R−V)
What Contribution Margin Can Tell You
The contribution margin is the foundation for break-even analysis used in the
overall cost and sales price planning for products. The contribution margin
helps to separate out the fixed cost and profit components coming from product
sales and can be used to determine the selling price range of a product, the
profit levels that can be expected from the sales, and structure sales
commissions paid to sales team members, distributors, or commission agents.
One-time costs for items such as machinery are a typical example of a fixed cost
that stays the same regardless of the number of units sold, although it becomes
a smaller percentage of each unit's cost as the number of units sold increases.
Other examples include services and utilities that may come at a fixed cost and
do not have an impact on the number of units produced or sold. For example, if
the government offers unlimited electricity at a fixed monthly cost of $100, then
manufacturing 10 units or 10,000 units will have the same fixed cost towards
electricity.
In these kinds of scenarios, electricity will not be considered in the contribution
margin formula as it represents a fixed cost. However, if the electricity cost
increases in proportion to consumption, it will be considered a variable cost.
Fixed costs are often considered sunk costs that once spent cannot be
recovered. These cost components should not be considered while taking
decisions about cost analysis or profitability measures.
The contribution margin is different from the gross profit margin, the difference
between sales revenue and the cost of goods sold. While contribution margins
only count the variable costs, the gross profit margin includes all of the costs
that a company incurs in order to make sales.
If a total of 10,000 ink pens are manufactured using the machine at a variable
cost of $6,000 and at a fixed cost of $10,000, the total manufacturing cost comes
to $16,000. The per-unit cost will then be computed as $16,000/10,000 = $1.6 per
unit. If each ink pen is sold at a price of $2 per unit, the profit per unit comes to
where:
SP=Sales price
TC=Total costs
However, the contribution margin does not account for fixed cost components
and considers only the variable cost components. The incremental profit earned
for each unit sold as represented by contribution margin will be:
where:
SP=Sales price
The contribution margin can help company management select from among
several possible products that compete to use the same set of manufacturing
resources. Say that a company has a pen-manufacturing machine that is
capable of producing both ink pens and ball-point pens, and management must
make a choice to produce only one of them.
If the contribution margin for an ink pen is higher than that of a ball pen, the
former will be given production preference owing to its higher profitability
potential. Such decision-making is common to companies that manufacture a
diversified portfolio of products, and management must allocate available
resources in the most efficient manner to products with the highest profit
potential.
Investors and analysts may also attempt to calculate the contribution margin
figure for a company's blockbuster products. For instance, a beverage company
may have 15 different products but the bulk of its profits may come from one
specific beverage.
Along with the company management, vigilant investors may keep a close eye
on the contribution margin of a high-performing product relative to other
products in order to assess the company's dependence on its star performer.
The company steering its focus away from investing or expanding the
manufacturing of the star product, or the emergence of a competitor product,
may indicate that the profitability of the company and eventually its share price
may get impacted.
Based on the contribution margin formula, there are two ways for a company to
increase its contribution margins; They can find ways to increase revenues, or
they can reduce their variable costs.
Variable costs tend to represent expenses such as materials, shipping, and
marketing, Companies can reduce these costs by identifying alternatives, such
as using cheaper materials or alternative shipping providers.
Alternatively, the company can also try finding ways to improve revenues. For
example, they can increase advertising to reach more customers, or they can
simply increase the costs of their products. However, these strategies could
ultimately backfire and result in even lower contribution margins.
The best contribution margin is 100%, so the closer the contribution margin is
to 100%, the better. The higher the number, the better a company is at covering
its overhead costs with money on hand.
Profit margin is the amount of revenue that remains after the direct production
costs are subtracted. Contribution margin is a measure of the profitability of
each individual product that a business sells.