Contribution Margin

Definition

Contribution Margin is a financial metric that measures the profitability for individual items that a company makes and sells. Specifically, it is used to review the variable costs included in the production cost of individual items. In essence, it shows how much of a company’s revenues will be contributing to covering its fixed costs and subsequently towards its profit.

Phonetic

The phonetic pronunciation of “Contribution Margin” is: /kon-truh-byoo-shun mahr-jin/

Key Takeaways

1. Measures Profitability: Contribution margin is a crucial financial metric that businesses use to decipher how profitability will be affected with each additional unit sold. It solely focuses on the variable costs associated with the production of each additional unit, allowing companies to gauge potential profitability with each sale.
2. Management Decision Tool: It acts as an essential management decision tool. When making pricing decisions, launching new products, or entering new markets, the contribution margin can provide useful insights for evaluating profit potential and risk evaluations.
3. Effect of Variable Costs: The contribution margin depends greatly on the company’s variable costs. If the variable costs are high, the contribution margin will be low, reducing the profitability from each additional unit. Therefore, effective management of variable costs is fundamental to improving the contribution margin.

Importance

Contribution margin is a critical financial metric in business as it delineates the profitability for individual items that a company makes and sells. Specifically, it is used to review the variable costs included in the production cost of individual items. Understanding the contribution margin is important because it shows how much a company’s sales can contribute towards covering fixed costs and then generating profit. Without contribution margin, a company can’t make pricing decisions, cannot prepare sales strategies and essentially, can’t understand its own potential for profitability. Thus, evaluating the contribution margin helps businesses determine the profitability of individual SKU’s, the break-even point for production and provides essential data for making informed business decisions.

Explanation

Contribution Margin plays a vital role in helping businesses make key operational decisions. It measures the profitability for individual items that a company makes and sells. Specifically, it’s useful in determining which products or service lines to focus on, based on their contribution margin. A company might opt to promote high-margin items in order to maximize profitability. It also helps the management in evaluating whether to add or subtract a line of business. For instance, if a product contributes negatively to the overall margin, a company might consider dropping that product line.Moreover, contribution margin is also pivotal in determining the break-even point of a business, that is, the point at which the company’s revenues cover all of its fixed and variable costs. It can be particularly useful in cost-volume-profit analysis and deciding pricing strategies. If a firm’s variable costs per unit decrease, the contribution margin per unit will increase, thus decreasing the number of units required to cover fixed costs. Therefore, understanding the concept of contribution margin is imperative for businesses, as it not only helps in boosting profitability but also plays a crucial role in strategic decision making.

Examples

1. Manufacturing Company: Suppose a company produces and sells widgets for $20 each. It costs them $5 in direct materials, $4 in direct labor, and $3 in variable overhead costs to make each widget. This means their contribution margin per widget is $20 – ($5 + $4 + $3) = $8 per widget. The contribution margin ratio would then be the contribution margin ($8) divided by the sales price ($20), resulting in a contribution margin ratio of 40%. This implies, for every additional widget they sell, $8, or 40% of the sales price, will contribute to covering fixed costs and generating profit.2. Food Truck Business: Consider a food truck that sells gourmet sandwiches for $10 each. The variable cost incurred on bread, filling, condiments, and packaging material is $3 per sandwich made. This leads to a contribution margin of $10 – $3 = $7 per sandwich. If the food truck’s fixed costs for items like rent and salaries total to $1400 a month, they’d need to sell at least 200 sandwiches in a month ($1400 fixed costs/$7 contribution margin) to break even.3. E-commerce Store: An online retailer sells a product for $100. The variable costs related to that product, including buying from a supplier, shipping, and packaging, total to $60. As such, the contribution margin for each product sold is $100 – $60 = $40. The contribution margin ratio would then be 40%. For every additional product sold, $40 or 40% of the sales price goes toward covering the fixed costs and potential profits.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Fixed Cost
• Variable Cost
• Gross Profit
• Break-Even Point
• Operating Leverages

Sources for More Information

• Investopedia
• Accounting Tools
• Corporate Finance Institute
• My Accounting Course