Contribution margin is a measure that indicates how much a business earns on each of the product it sells, after deducting its variable costs. The contribution margin results from multiplying the price per unit by the number of units sold minus the variable cost per unit times the number of units sold. The resulting figure its later on employed to cover for the business fixed costs and it is used to determine what is known as the break-even point.
What is a Contribution Margin?
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The contribution margin is a metric employed by businesses to estimate how much a product, a business or an entire company brings in profits after the variable costs related to the production process are deducted. These variable costs are those that fluctuate depending on the production levels or the sales volume. The higher the sales volume, the higher the total variable costs will be and so on.
Estimating the contribution margin for a single product will give the business the opportunity to estimate the product’s break-even point, which is the minimum number of units that the business has to sell to cover for all of the fixed costs related to the product. In turn, estimating the contribution margin for an entire business will determine how many units of all of its products combined the business has to sell in order to cover for all of its fixed costs. For this reason, the metric is particularly useful to understand how sustainable and profitable a product or a business are, considering their current cost structure.
Contribution Margin Formula
The formula to calculate the Contribution Margin per unit would be:
CM = P – VC
While the formula to calculate the contribution margin for a given number of units would be:
CM = (P – VC) * Q
Contribution Margin Equation Components
P: Price per unit.
VC: Variable costs per unit. These include direct materials, packaging, direct labor and manufacturing overhead.
Q: Production volume in units.
Additionally, the contribution margin can be estimated as a percentage of the price or a percentage of the total sales. This metric is known as the Contribution Margin Ratio and its formula is:
CMR = CM / P ; or, as a percentage of total sales: CMR = (CM * Q) / (P * Q)
Contribution Margin Calculation Example
PaperMill Co. is a business that manufactures paper sheets of many different kinds. Currently the business is trying to estimate the margin of contribution of a new product they recently develop, which is a colored paper ream. The information provided to estimate such margin is the following:
Price per unit: $21
Cost of Direct Labor per unit: $3.1
Cost of Direct Materials per unit: $5.6
Manufacturing Overhead per unit: $1.1
Fixed costs associated to this product line: $120,000 per year
By employing the formula provided above, the Contribution Margin for this product would be:
CM = $21 – ($3.1 + $5.6 + $1.1) = $11.2
This means that for each colored ream produced and sold, the company would earn $11.2 to cover for its fixed costs. Additionally, the Contribution Margin Ratio, for the product would be:
CMR = $11.2 / $21 = 53.33%
Furthermore, in order to calculate how many units of colored paper reams PaperMill would have to produce to cover for its fixed costs, a break-even analysis can be done, as follows:
Q = $120,000 / $11.2 = 10,714 units.
In order to reach the break-even point, which is the point at which the product can cover for its fixed costs, PaperMill has to produce and sell 10,714 units of colored paper reams.
Contribution Margin Analysis
The Contribution Margin is a very useful metric for businesses to understand how much a product yields in profits in order to cover for its fixed costs and produce a profit. In the example above, the colored paper reams had a Contribution Margin of 53%, which is a good margin. The higher this margin is, the more money the company is producing per unit to cover for its fixed costs. Therefore, it is convenient for businesses to pursue strategies to reduce variable costs, such as the cost of direct labor, direct materials or manufacturing overhead, in order to increase the Contribution Margin. Additionally, the company could also explore the possibility of increasing its price per unit as another way to widen this margin.
Also, if the business can expand its production and sales volume, this will eventually lead to a higher net profit margin, as fixed costs will remain stable and the total contribution margin will continue to grow, as production volumes grow. This situation is known as economies of scale.
Now that PaperMill understands how many reams per year it has to produce in order to cover for its variable and fixed costs, it can also plan how many units it will need to sell to achieve a certain profit’s target.
Companies often look to find a balance between the proportion of fixed and variable costs of its products. The higher the proportion of variable costs, the easier will be for the company to cover for its fixed costs. This provides a certain degree of flexibility, as it reduces the number of units required to achieve break-even. In turn, the higher the proportion of fixed costs is, the more difficult it is for the business to remain profitable if there’s a sales downturn, as the number of units required to achieve break-even is high.
Contribution Margin Uses, Cautions, Pitfalls
Being able to identify which costs are variable and which are fixed is essential to adequately estimate the actual Contribution Margin. Variable costs are those that fluctuate with the sales volume. These variable costs can also be sales commissions, certain type of fees and other financial items that vary in direct proportion to the business’ sales. On the other hand, fixed costs, regardless of where the sales volume is, will remain the same over time.
Yet, even though fixed costs may be fixed under most circumstances, there are situations in which fixed costs may vary. For example, the cost of renting a facility may go up, or the total salaries for the administrative departments may increase. Even though this may be the case, fixed costs commonly remain the same for at least a year. In any case, if there’s an increase in fixed costs, the Contribution Margin required to achieve the break-even point will be higher.