Contribution Margin

1,2What is Contribution Margin?

Contribution margin means the selling price minus the variable cost incurred on the product. Thus, it is the ability of the firm to cover its variable cost with the revenue. The remaining amount i.e. the contribution covers fixed cost or is the profit earned by the business.

The calculation of contribution margin is of great significance for any business. It not only helps the business to evaluate its profitability, but it also helps to know the margins of different product lines. By determining the contribution margin of different products, the business knows which product gives more margins and which product line is underperforming. Based on the analysis, the business can frame strategies and take necessary actions. By compiling the data, the company can increase the sales of the products that yield higher margins.

Let us now understand how to find contribution margin.

How to Find Contribution Margin

The contribution margin concept gives the business the actual amount the company needs to cover its fixed costs after it pays its variable cost. Therefore, to find the contribution margin, there is a formula.

Contribution Margin Formula

Contribution Margin = Sales Revenue – Variable Expenses

Let us take an example to understand the application of contribution margin formula.

Example of Contribution Margin

Suppose ABC Ltd. sells a product for $ 200. The variable cost per unit is $ 80. The variable cost per unit includes direct material expense, labor expense and variable overhead cost. The fixed overhead cost is $ 20. Calculate the contribution margin.

In the question, the fixed overhead cost is given separately. It shall not be included in the calculation of contribution margin, as it does not form part of the formula.

Contribution Margin = Sales Revenue – Variable Expenses

= $ 200 – $ 80

= $ 120

Therefore, the contribution margin per unit is $ 120.

Conclusion

The contribution margin is very useful for businesses. By using this formula, the business can frame its pricing policies. The real worth of it is known when the business has a proposal and decision regarding its acceptance or rejection is to be made. In such scenario, contribution margin calculation comes handy. The business can evaluate the worthiness of the proposal by looking at the contribution margin.

By using this concept, the business can give a lease of life to the business by allocating more resources towards products that have higher contribution margin per unit. Thus, it will not be wrong to say that every business uses the contribution margin formula to know the returns from different products.

References:

1.
Contribution Margin: What It Is, How to Calculate It, and Why You Need It. Harvard Business Review. October 2017. [Source]
2.
Contribution Margin Definition | Contribution Margin Example. The Strategic CFO. July 2013. [Source]
Sanjay Bulaki Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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