Description: The contribution margin is a product’s price minus its variable costs, resulting in the incremental profit earned for each unit sold. The total contribution margin generated by an entity represents the total earnings available to pay for fixed expenses and generate a profit.
The measure is useful for determining whether to allow a lower price in special pricing situations. If the contribution margin is excessively low or negative, it would be unwise to continue selling a product at that price point. It is also useful for determining the profits that will arise from various sales levels (see the example). Further, the concept can be used to decide which of several products to sell if they use a common bottleneck resource, so that the product with the highest contribution margin is sold.
The contribution margin concept can be applied throughout a business, for individual products, product lines, profit centers, subsidiaries, and for an entire business.
Formula: Subtract all variable costs of a product from its revenues, and divide by its revenue. The calculation is:
Product revenue - Product variable costs
Example: The Iverson Drum Company sells drum sets to high schools. In the most recent period, it sold $1,000,000 of drum sets that had related variable costs of $400,000. Iverson had $660,000 of fixed costs during the period, resulting in a loss of $60,000.
Iverson’s contribution margin is 60%, so if it wants to break even, it needs to either reduce its fixed expenses by $60,000 or increase its sales by $100,000 (calculated as $60,000 loss divided by 60% contribution margin).
Cautions: The contribution margin does not account for the impact of a product on the bottleneck operation of a company. A low contribution margin may be entirely acceptable, as long as it requires little or no processing time by the bottleneck operation. See the throughput article for more information.