What Is Contribution Margin?
The contribution is the difference between the market price of the product and its variable cost, where variable cost is the production cost excluding the company’s own fixed costs of operating the business.
Variable costs are the material and labor costs of making the product. Those costs will vary with the quantity produced.
Fixed costs are costs that are attributable to the process as a whole and not to any individual unit of product. Fixed costs may be the costs of machinery and equipment or of the company itself, i.e., “overhead”; they are costs incurred regardless of the number of units produced.
Contribution Margin Formula
There are a few ways to calculate contribution margin:
- Contribution margin per unit = Price (revenue) per unit – Variable cost per unit
- Contribution margin per unit = (Total revenue – Total variable costs)/Number of units sold
How Contribution Margin Works
A more labor intensive production process will have a lower contribution margin, because more of its costs are variable. A more capital intensive process will have a higher contribution margin, because more of the production costs are fixed costs.
To increase the contribution margin, a company would try to shift costs from variable to fixed, for example, by purchasing equipment that can replace labor.
Contribution Margin Example
Say a machine for manufacturing phone cases costs $5,000. Manufacturing one phone case requires $0.50 worth of raw materials like rubber, and another $0.50 goes towards the electricity charges for running the machine and the wages of the machine operator. The total variable cost of manufacturing a phone case comes to $1.00 (0.50 + 0.50) total per unit.
If a total of 100 phone cases are manufactured, the total variable cost will come to $100, ($1.00 × 100 units) while manufacturing 10,000 phone cases will lead to a total variable cost of $10,000. The cost increases in direct proportion to the number of units manufactured.
However, the production will not be possible without the machine that comes at a fixed cost of $5,000. This cost of the machine represents a fixed cost since its charges do not increase based on the units produced.
If a total of 10,000 phone cases are manufactured using the machine, and with a variable cost of $10,000 and a fixed cost of $5,000, the total manufacturing cost comes to $15,000. The per-unit total cost will then be computed as $15,000/10,000 = $1.50 per phone case. If each phone case is sold at a price of $2.00 per unit, the profit per unit comes to $0.50.
In this example, the contribution margin is $2.00 – $1.00 = $1.00 per unit.
Contribution Margin vs. Gross Margin
Contribution margin is a measure of the profitability of various individual products, while gross profit measures the amount of revenue that remains after subtracting costs directly associated with production.
Gross profit margin is calculated by finding the gross profit as a percentage of revenue:
Why Is Contribution Margin Important?
The contribution margin can help a business choose from several possible products that are created using the same set of manufacturing resources.
It can help to show management which of its products can contribute most to the business’s profits, and thus how to best allocate its limited resources. Very low or negative contribution margin values indicate unprofitable products whose manufacturing and sales may be discontinued.
Investors, analysts, and competitors may also try to calculate the contribution margin figure for a company's products in order to see how efficiently the company is using its productive assets.
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