What is the contribution margin?

The contribution margin represents the incremental sum of finances generated for each particular unit of a product sold. The contribution margin is often stated on a gross or, also known as per-unit basis. What is more, to understand the concept, one also needs to deduct the variable portion of a company’s fixed costs.

The key to contribution margin stems from the computation of the selling price per unit of a particular product. Yet, the notion also includes the correlation to the factor of the variable cost, also known as dollar contribution per unit. This measures how a particular product makes a contribution to the overall degree of profit generated.

Keeping the insights in mind, the contribution margin shows what a particular profit potential of a specific product the company offers is. Besides, it illustrates what portion of this product’s sales is needed to help cover the company’s degree of fixed costs. In such a context, any revenue remaining after the fixed cost aspect is covered will be the profit generated.

Put simply, the contribution margin is a term used to describe the despite of making a product or delivering a service while deducting the variable costs of delivering the product. In such a case, all the remains left will be profit. The contribution margin shows the aggregate amount of revenue to cover fixed expenses and profit the profit to a particular company.

The formula for contribution margin?

Companies use the contribution margin for many reasons. Most notably, the phenomenon serves as the foundation for break-even analysis often employed in the overall cost and sales price planning for all products in the company’s portfolio. The contribution margin allows one to separate the factor of the fixed cost. What is more, the contribution margin is often coupled with the key difference between the variable price associated with the product, the sales process, and the sales price.

You can get the contribution margin with the following formula: contribution margin equals revenue minus variable costs. To illustrate, if the price for a product is $10 and the variable cost is $2, then the contribution margin will be $8. There is simple arithmetic involved in the process of contribution margin calculation.

When it comes to approaching the calculator process, there are several steps involved. The first step in calculating is taking the income statement and recategorizing all costs as either fixed or variable. The process is not straightforward and might be challenging. Namely, it is so because there are no clear indications of which costs fall into each category.

In the second step, one should remember that fixed costs are business costs and remain the same regardless of circumstances. It does not matter how much your volume of production is. In turn, variable costs are the ones that vary with a particular quantity of a product offered. These can be direct materials and sales commissions.

Finally, calculating the contribution margin is also about considering aspects like factory costs, equipment in the product, utility costs, and labor used in the production process. These are all fixed costs and must be considered to get an as precise calculation for contribution margin as possible.

How do companies use contribution margin?

When it comes to ways companies can use contribution margin, there are many scenarios to mention. As the foundation for break-even analysis, the contribution margin plays an integral role in the sales price and cost planning for products within a company’s portfolio. In such a case, the contribution margin separates the fixed costs from all the given profit components from direct product sales. It is required to determine the selling price range for a certain product.

Besides, companies use the contribution margin to establish a selling price and later use the information to establish further the profit levels a firm can expect from the sales. Such an indication also helps structure sales commissions paid to all the sales team members, commission agents, and distributors. Keeping that in mind, the company can use the knowledge for proper management and resource allocation strategies.

Going further, the contribution margin can be used for better decision-making. From a general perspective on the market, one can consider the following example. There is a company producing ink pens while another firm produces ball pens. If the calculation shows the contribution margin for an ink pen is much higher than the contribution margin of a ball pen, the former will be given product preference. In simple terms, a company producing ink pens will have a competitive advantage and demand. In such a case, the contribution margin grants business-based decision-making that establishes the future objectives for a product.

Analysts and investors can use contribution margin to determine the so-called blockbuster products. Essentially, the notion can be employed to find the products with the highest profit potential. For instance, a company can have ten products in a portfolio. However, the bulk of its profits is received from one specific product. Along with the business’s management, the investors can close their eyes on the most prospective product as a high-performing product in correlation to different products in a portfolio.

Finally, the contribution margin can be used to assess the overall condition of products in any given market. In such a case, a low or negative contribution margin suggests economically nonviable products. Such evidence shows companies that the manufacturing process and sales for such a product should be discarded. In a similar manner, low values of contribution margin can be examined within labor-intensive industries. These are the ones having higher variable costs. Yet, higher values for contribution margin are prevalent for capital-intensive markets.

Overall, one should indicate that the concept of contribution margin is a broad application to manufacturing. The figure for contribution margin can be calculated for the entire corporation. In turn, it can also be computed for a particular division or unit and for individual products. The contribution margin is the broadly applicable notion that companies can use in various scenarios.

Concluding remarks

The contribution margin is the phenomenon that helps discern prospective products that profit from the ones that need to be discarded from the market and manufacturing. One must get into an accounting variable and fixed costs to calculate the contribution margin. Keeping these aspects in mind, the phenomenon can be applied to several scenarios. From determining the price-based decision-making to establishing the selling price that will bring the most profits.

FAQ

Find answers to some of the most common questions people have regarding the use of Competera.

How does price affect contribution-based pricing?

The contribution-based pricing depends on a price affecting a contribution margin by introducing the factors of variable and fixed costs within the further scope to lower the price per unit within a particular product margin.

What happens to contribution-based pricing if the selling price increases?

When the selling price increase and the fixed cost factor starts playing a more important role, the contribution margin goes down. It is about pricing contribution and the company’s ability to use variable and fixed costs.