Contribution margin

Definition

Contribution margin is equal to sales revenue less total variable expenses incurred to earn that revenue. Total variable expenses include both manufacturing and non-manufacturing variable expenses. In a service firm, contribution margin is equal to revenue from provision of services less all variable expenses incurred to provide such services.

Contribution margin is the amount by which an item contributes towards covering fixed costs and profitability of the business. It is therefore a very important input for many CVP decisions and is usually computed for a single product, multiple products together, a particular profit center and the business as a whole depending on the need of the management.

Formula

The equation or formula of contribution margin can be written as follows:

Contribution margin = Sales revenue – Variable expenses

The concept can best be explained with the help of an example

Example 1

The Fine Manufacturing Company provides you the following data for the year 2017.

Production and sales data:

  • Number of units produced and sold: 1,000 units
  • Sales price per unit: $10
  • Total sales revenue: 1,000 units × $10 = $10,000

Variable expenses data:

  • Per unit variable manufacturing expenses: $4
  • Total variable manufacturing expenses: 1,000 units × $4 = $4,000
  • Per unit variable marketing and administrative expenses: $1
  • Total variable marketing and administrative expenses: 1,000 units × $1 = $1,000

Fixed expenses data:

  • Total fixed manufacturing expenses: $2,000 per year
  • Total fixed marketing and administrative: $500 per year

Inventories data:

There was no work-in-process and finished goods inventory at the start and end of the year 2017.

Required: From the data given above, calculate contribution margin and net operating income of Fine Manufacturing Company for the year 2017.

Solution

1. Contribution margin = Sales revenue – Variable expenses

= $10,000 – ($4,000 + $1,000)

= $10,000 – $5,000

= $5,000

2. Net operating income = Contribution margin – Fixed expenses

= $5,000 – ($2,000 + $500)

= $5,000 – $2,500

= $2,500

The use of equation to calculate contribution margin figure is just for explaining the concept. For managerial use, a proper contribution margin income statement is prepared to compute this figure. See the format of contribution margin income statement.

Importance of contribution margin

The amount of contribution margin should be sufficient to cover all fixed costs as well as to contribute towards profit. If the amount of contribution margin is not enough to cover all fixed costs, the business will suffer a loss.

Contribution margin figure is even more important for multi product companies. Normally, all products sold by a company are not equally profitable. High contribution margin products are more profitable because they contribute more for covering fixed costs and providing for profit. A multi product company can increase its net operating profit by focusing its attention to increase the sales of high contribution margin products or finding the ways to reduce variable cost of low contribution margin products. Read this article to understand the importance of higher contribution margin products for a multi product company.

Example 2

The Eastern company sells a single product known as product-X. The selected data of the company is given below:

  • Sales price: $175 per unit
  • Variable manufacturing cost: $100 per unit manufactured
  • Variable selling and administrative cost: $25 per unit sold
  • Number of units manufactured and sold during the period: 5,000 units

Required: Using the information provided by Eastern Company, calculate per unit and total contribution margin of product-X.

Solution

1. Contribution margin per unit = Sales price per unit – Variable expenses per unit

= $175 – $125*

= $50 per unit

*$100 + $25

2. Total contribution margin = Sales revenue – Variable expenses

= $875,000* – $625,000**

= $250,000

*5,000 units × $175
**(5,000 units × $100) + (5,000 units × $25)

Or

Total contribution margin = Number of units sold × Contribution margin per unit

= 5,000 units × $50

= $250,000

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5 Comments on Contribution margin

  1. Arfan

    This is one of the most valuable post for me. Thank you for writing.

  2. Matt

    You have not discussed about CM ratio in this article. I need it for my home work and assignments. Can you please post formula and explain the procedure to calculate contribution margin ratio with the help of an example?

  3. Rashid Javed

    Thank you for using our site for your studies. Actually I was planning to write a separate article about it. It is equal to contribution margin divided by total sales revenue and the formula or equation can be written as follows:

    CM ratio = Contribution margin / Sales revenue

    For further explanation, suppose the sales revenue of your business is $25,000 and the contribution margin (explained above) is $10,000. The CM ratio would be 0.4 or 40%.

  4. Malaysia

    Good information, thanks. Can I say variable expenses refer to Direct Product costs of material to produce a finished good? And exclude direct labour cost?

  5. Accounting For Management

    No, all variable direct labor expenses of the business must be included in the total variable expenses. In most of the cases direct labor cost is treated as variable cost. However, if direct labor cost is clearly a fixed cost, then it is excluded from the variable expenses of that particular company.

    Usually total variable expenses consist of:
    (1). Direct materials expenses
    (2). Direct labor expenses
    (3). Variable portion of manufacturing (or factory overhead)

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