The weighted average contribution margin is the average amount that a group of products or services contribute to paying down the fixed costs of a business. The concept is a key element of breakeven analysis, which is used to project profit levels at varying sales levels. Its main weakness is that projections based on this average margin incorporate the assumption that the same mix of product sales and margins will apply in the future, which is not necessarily the case.
The measurement is compiled by accumulating the revenue for all items being measured, subtracting from this aggregate revenue figure the total amount of all variable expenses related to the items in the measurement group, and dividing by the number of units sold.
For the purposes of this calculation, variable expenses are those that vary directly with sales. Thus, an expense is only incurred if a sale is generated. Examples of these variable expenses are:
- Direct materials
- Production supplies
- Piece rate wages
- Freight out
Thus, the calculation of the weighted average contribution margin is:
(Aggregate sales - Aggregate variable expenses) / Number of units sold
For example, ABC International has two product lines, each of which is responsible for 50% of sales. The contribution from Line A is $100,000 and the contribution from Line B is $50,000. In aggregate, ABC sold 15,000 units. This means that the weighted average contribution margin for the entire business is $10/unit (calculated as $150,000 total contribution / 15,000 units).
The weighted average contribution margin is useful for calculating the number of units that a business must sell in order to cover its fixed expenses and at least break even, if not earn a profit. This analysis is known as cost-volume-profit analysis.
To continue with the example, ABC International has calculated that it generates a contribution margin of $10 per unit, based on current sales of 15,000 units. However, the business also has $200,000 of fixed costs, so it is currently losing $50,000 per period. ABC can use the weighted average contribution margin to calculate how many units it must sell in order to break even. Thus, fixed costs of $200,000 divided by a contribution margin of $10 per unit results in a requirement of 20,000 in unit sales in order to break even.