Contribution Margin

what is Contribution margin?

Contribution margin is a product’s price minus all associated variable costs, resulting in the incremental profit earned for each unit sold. The total contribution margin generated by an entity represents the total earnings available to pay for fixed expenses and to generate a profit.In accounting contribution margin is defined as revenues minus variable expenses. In other words, the contribution margin reveals how much of a company's revenues will be contributing (after covering the variable expenses) to the company's fixed expenses and net income. The contribution margin can be presented as:

 1) the total amount for the company,

 2) the amount for each product line, 

3) the amount for a single unit of product, and 

4) as a ratio or percentage of net sales.

The contribution margin concept is useful for deciding whether to allow a lower price in special pricing situations. If the contribution margin at a particular price point is excessively low or negative, it would be unwise to continue selling a product at that price. It is also useful for determining the profits that will arise from various sales levels (see the example). Further, the concept can be used to decide which of several products to sell if they use a common bottleneck resource, so that the product with the highest contribution margin is given preference.

The contribution margin concept can be applied throughout a business, for individual products, product lines, profit centers, subsidiaries, distribution channels, sales by customer, and for an entire business.

To determine the contribution margin, subtract all variable costs of a product from its revenues, and divide by its net revenue. Product variable costs typically include, at a minimum, the costs of direct materials and sales commissions. The calculation is:

              Net product revenue - Product variable costs

                                Product revenue

Contribution Margin Ratio (CM Ratio)

Contribution margin is a product's price minus all associated variable costs, resulting in the incremental profit earned for each unit sold. The total contribution margin generated by an entity represents the total earnings available to pay for fixed expenses and to generate a profit.The contribution margin ratio is the difference between a company's sales and variable expenses, expressed as a percentage. The total margin generated by an entity represents the total earnings available to pay for fixed expenses and generate a profit. When used on an individual unit sale, the ratio expresses the proportion of profit generated on that specific sale.

The contribution margin should be relatively high, since it must be sufficient to also cover fixed costs and administrative overhead. Also, the measure is useful for determining whether to allow a lower price in special pricing situations. If the contribution margin ratio is excessively low or negative, it would be unwise to continue selling a product at that price point, since the company would have considerable difficulty earning a profit over the long term. However, there are cases where it may be acceptable to sell a package of goods and/or services where individual items within the package have a negative contribution margin, as long as the contribution margin for the entire package is positive.

The contribution margin ratio is also useful for determining the profits that will arise from various sales levels (see the example).

The contribution margin is also useful for determining the impact on profits of changes in sales. In particular, it can be used to estimate the decline in profits if sales drop, and so is a standard tool in the formulation of budgets.

To calculate the contribution margin ratio, divide the contribution margin by sales. The contribution margin is calculated by subtracting all variable costs from sales. The formula is:

                         Sales - Variable expenses

                                       Sales

Contribution Margin Income Statement Contribution margin income statement is an income statement that is prepared to show the contribution margin figure in the income statement. A traditional income statements or profit or loss accounts prepared for external parties like govt. agencies, shareholders, auditors show gross profit and net profit and do not show contribution margin figure. A contribution margin income statement is prepared for the use of internal management. In such statements, all variable (manufacturing and non-manufacturing) and fixed (manufacturing and non-manufacturing) expenses are shown separately. When all variable manufacturing expenses are deducted from the sales revenue, the resultant figure is gross contribution margin. And when all non-manufacturing variable expenses are deducted from the gross contribution margin, the resultant figure is contribution margin or net contribution margin.