The unit contribution margin is the remainder after all variable costs associated with a unit of sale are subtracted from the associated revenues. It is useful for establishing the minimum price at which to sell a unit (which is the variable cost). This margin analysis can apply to the sale of either goods or services.
The formula for unit contribution margin is:
(Unit-specific revenue - unit-specific variable costs) ÷ Unit-specific revenue
The amount of variable expense to use in the calculation varies considerably, depending on the situation.
Consider the following examples of how this margin can be used:
- At the individual unit level for products, the only variable costs are usually for the direct materials and supplies that are consumed in the production process. Labor is not considered a variable cost at the individual unit level, unless employees are being paid based on the number of units produced (such as under a piece rate pay plan).
- At the individual unit level for services (such as for one billable hour of work) there may be no variable cost at all if the person performing the work is salaried, since that person will be paid irrespective of providing the service.
- If a person is paid based on the time worked on a specific billable service, then the variable cost is his or her hourly wage and related payroll taxes - those costs that the company would not otherwise incur if it did not provide the unit of service.
However, this cost may change if a specific sale transaction includes more than one unit, since purchasing or production efficiencies may then reduce the variable cost, resulting in a different contribution margin. Thus, the unit contribution margin may not be relevant for pricing decisions in unit quantities of greater than one.
Conversely, the concept is highly applicable to products that are produced in small batches, since the impact of cost reductions from high-volume manufacturing do not apply.