Contribution margin is the margin that results when all variable expenses are subtracted from revenue. It is most useful for making incremental pricing decisions for selling small numbers of units, where an entity must cover its variable costs, though not necessarily all of its fixed costs; for the purposes of this analysis, fixed costs are assumed to be sunk costs. If a proposed price results in a zero or negative contribution margin, then the deal should not be accepted.
The concept can be employed in the construction of a contribution margin income statement, which pushes all fixed costs (such as factory overhead) lower down in the report format. However, the contribution margin format is not used for external reporting of a company's income statement.
The calculation of the contribution margin ratio is:
(Revenues - Variable costs) / Revenues
For example, a business has $1,000,000 of revenues and $350,000 of variable expenses in a period. Based on this information, the contribution margin is 65%.
Contribution margin is an essential component of the cost-volume-profit relationship, where the analyst wants to determine the number of units that must be sold at a certain price point in order to break even.