Contribution margin is the revenue from a sale transaction, less all variable costs associated with that sale. The resulting margin represents the amount of cash that is available for paying fixed costs and earning a profit. The concept is frequently used to establish the lowest price at which a product or service can be sold in incremental unit pricing situations.
The steps to follow to calculate contribution margin for a specific sale transaction are as follows:
- Net the gross sale amount against any deductions, such as for sales allowances, to arrive at the net revenue figure.
- Aggregate all variable costs associated with the sale. Examples of these costs are the direct materials, direct labor, shipping cost, and commission associated with the product sold. If the transaction was for services instead of sales, then the variable costs are likely to be the labor associated with the sale, plus related payroll taxes and any benefits that vary with hours worked.
- Subtract the aggregated variable costs from the net revenue figure.
- If you want to derive the contribution margin ratio, then divide the contribution margin into the net sales figure.
For example, ABC International completes a sale transaction for which the gross sale amount is $100,000, and to which a volume discount of $8,000 applies, resulting in a net sale of $92,000. The transaction is for a product sale, where the direct cost of the product is $50,000. The salesman who completed the deal will receive a $2,000 commission, so the aggregated amount of all variable costs is $42,000. Based on this information, the contribution margin is:
$92,000 Net revenue - $52,000 Variable expenses = $40,000 Contribution margin
This ratio is only used from the perspective of deriving the lowest possible acceptable price for a unit. In reality, a variety of other pricing concepts can be used to establish higher price points for products.