Variable contribution margin is the margin that results when variable production costs are subtracted from revenue. It is most useful for making incremental pricing decisions where an entity must cover its variable costs, though not necessarily all of its fixed costs. It is particularly useful when determining margins for short-term pricing decisions, such as pricing a single order to a customer. It is not advisable to set a price that results in a small or negative variable contribution margin, since the seller will be unable to earn a profit. The concept is least useful for long-term pricing decisions, where a company must set prices high enough to cover its fixed costs.
The steps needed to calculate the variable contribution margin for a product or service are:
- Determine the price. This is the amount at which a product or service sells, minus any allowances for doubtful accounts or reductions for early payment discounts.
- Determine variable costs. This includes only those costs that vary directly with the volume of units sold. If the calculation is being made for a product, this typically includes direct materials, commissions, and inbound and outbound shipping costs. If the calculation is being made for services, this typically includes the cost of labor, variable benefits, payroll taxes, and commissions.
- Subtract all variable costs from the price. This results in the variable contribution margin.
Costs that should not be included in the variable contribution margin calculation include factory overhead (such as rent, supervisory salaries, and machine maintenance) and selling and administrative expenses (with the exception of commissions).
The variable contribution margin differs from the gross margin in that the gross margin also incorporates factory overhead costs, which can result in significantly lower margins. A margin analysis using gross margin information is not as useful for incremental pricing decisions, since it includes allocated overhead costs that may not be relevant.
Example of Variable Contribution Margin
ABC International wants to determine the variable contribution margin associated with the sale of its green widget product. The widget sells for a net price of $10. Its variable costs are $3.50 for materials, $0.25 for inbound freight, and $0.50 for a sales commission. The calculation is:
$10 Price - ($3.50 Materials + $0.25 Freight + $0.50 Commission)
= $5.75 Variable contribution margin
The $5.75 variable contribution margin represents margin that is available for the payment of fixed costs.
Variable contribution margin is also known as contribution margin.