Defining the Contribution Margin
Companies often look at the minimum price at which a product could sell to cover basic, fixed expenses of the business. Fixed expenses do not vary with an increase or decrease in production. They include building rent, property taxes, business insurance, and other costs the company pays, regardless of whether it produces any units of product for sale. This minimum-sale-price analysis is called a break-even analysis. One of the important pieces of this break-even analysis is the contribution margin, also called dollar contribution per unit. Analysts calculate the contribution margin by first finding the variable cost per unit sold and subtracting it from the selling price per unit. Variable costs fluctuate with the level of units produced and include expenses such as raw materials, packaging, and the labor used to produce each unit. The result of this calculation shows the part of sales revenue that is not consumed by variable costs and is available to satisfy fixed costs, also known as the contribution margin. Typically, low contribution margins turn up in labor-intensive service businesses, while high contribution margins are prevalent in more capital-intensive industrial businesses that require costly machinery and large production facilities. Contribution margin analysis also helps companies measure their operating leverage. Companies that sell products or services that generate higher profit with lower fixed and variable costs have very good operating leverage.
The Formula and Result
The contribution margin ratio is a formula that calculates the percentage of contribution margin (fixed expenses, or sales minus variable expenses) relative to net sales, put into percentage terms. The answer to this equation shows the total percentage of sales income remaining to cover fixed expenses and profit after covering all variable costs of producing a product.
Calculating the Contribution Margin and Ratio
In order to calculate the contribution margin ratio, you’ll first need to calculate the contribution margin. You can calculate the contribution margin in one of two ways. Use the following formula to calculate the contribution margin ratio: Contribution Margin Ratio = Contribution Margin / Sales Revenue The contribution margin ratio can help companies calculate and set targets for the profit potential of a given product.
Example of a Contribution Margin
Assume that ABC Widgets produces and sells one product at a retail price of $20 each. It needs to pay the following fixed costs each month:
$18,000 for machinery$12,000 for general office expenses$1,000 for loan interest
The variable costs equal $6, because the company pays $4 to manufacture each unit and $2 for the labor to create unit.
These factors result in a contribution margin of $14 per unit. The calculation is as follows:
Contribution Margin = ($20 sales income - $6 total variable costs) = $14
It also results in a contribution margin ratio of $14/$20, or 70 percent. From this calculation, ABC Widgets learns that 70 percent of each product sale is available to contribute toward the $31,000 of total fixed expenses it needs to cover each month and also help achieve its profit target.
What Is a Good Contribution Margin?
The higher the margin, the better. The higher your company’s ratio result, the more money it has available to cover the company’s fixed costs or overhead. A good contribution margin is all relative, depending on the nature of the company, its expense structure, and whether the company is competitive with its business peers. Look at the contribution margin on a per-product or product-line basis, and review the profitability of each product line. Selling products at the current price may no longer make sense, and if the contribution margin is very low, it may be worth discontinuing the product line altogether. This strategy can streamline operations and have a positive impact on a firm’s overall contribution margin. For variable costs, the company pays $4 to manufacture each unit and $2 labor per unit. That means the company pays $6 in total variable costs. The company sells the unit for $20 per unit. Contribution Margin = $20-$6 The contribution margin in this example would be $14. Contribution Margin Ratio = (Sales Income - Total Variable Costs) / Sales Revenue The contribution margin ratio represents the marginal benefit of producing one more unit.
