Contribution margin (CM), or dollar contribution per unit, is the selling price per unit minus the variable cost per unit. "Contribution" represents the portion of sales revenue that is not consumed by variable costs and so contributes to the coverage of fixed costs. This concept is one of the key building blocks of break-even analysis.
In cost-volume-profit analysis, a form of management accounting, contribution margin—the marginal profit per unit sale—is a useful quantity in carrying out various calculations, and can be used as a measure of operating leverage. Typically, low contribution margins are prevalent in the labor-intensive service sector while high contribution margins are prevalent in the capital-intensive industrial sector.
Purpose
In Cost-Volume-Profit Analysis, where it simplifies calculation of net income and, especially, break-even analysis.
Given the contribution margin, a manager can easily compute breakeven and target income sales, and make better decisions about whether to add or subtract a product line, about how to price a product or service, and about how to structure sales commissions or bonuses.
Contribution margin analysis is a measure of operating leverage; it measures how growth in sales translates to growth in profits.
The contribution margin is computed by using a contribution income statement, a management accounting version of the income statement that has been reformatted to group together a business's fixed and variable costs.
Contribution is different from gross margin in that a contribution calculation seeks to separate out variable costs (included in the contribution calculation) from fixed costs (not included in the contribution calculation) on the basis of economic analysis of the nature of the expense, whereas gross margin is determined using accounting standards. Calculating the contribution margin is an excellent tool for managers to help determine whether to keep or drop certain aspects of the business. For example, a production line with positive contribution margin should be kept even if it causes negative total profit, when the contribution margin offsets part of the fixed cost. However, it should be dropped if contribution margin is negative because the company would suffer from every unit it produces.
The contribution margin analysis is also applicable when the tax authority performs tax investigations, by identifying target interviewees who have unusually high contribution margin ratios compared to other companies in the same industry.
Contribution margin is also one of the factors to judge whether a company has monopoly power in competition law, such as use of the Lerner Index test.
Contribution
The Unit Contribution Margin (C) is Unit Revenue (Price, P) minus Unit Variable Cost (V):
The Contribution Margin Ratio is the percentage of Contribution over Total Revenue, which can be calculated from the unit contribution over unit price or total contribution over Total Revenue:
For example, if the price is $10 and the unit variable cost is $2, then the unit contribution margin is $8, and the contribution margin ratio is $8/$10 = 80%.
Contribution margin can be thought of as the fraction of sales that contributes to the offset of fixed costs. Alternatively, unit contribution margin is the amount each unit sale adds to profit: it is the slope of the profit line.
Cost-Volume-Profit Analysis (CVP): assuming the linear CVP model, the computation of Profit and Loss (Net Income) reduces as follows:
where TC = TFC + TVC is Total Cost = Total Fixed Cost + Total Variable Cost and is Number of Units. Thus Profit is the Contribution Margin times Number of Units, minus the Total Fixed Costs.
The above formula is derived as follows:
From the perspective of the matching principle, one breaks down the revenue from a given sale into a part to cover the Unit Variable Cost, and a part to offset against the Total Fixed Costs. Breaking down Total Costs as:
one breaks down Total Revenue as:
Thus the Total Variable Costs offset, and the Net Income (Profit and Loss) is Total Contribution Margin minus Total Fixed Costs:
Combined Profit Volume Ratio can be calculated by using following formula
Combined Profit Volume Ratio = Combined Contribution/Combined Sale * 100
Examples
The Beta Company's contribution margin for the year was 34 percent. This means that, for every dollar of sales, after the costs that were directly related to the sales were subtracted, 34 cents remained to contribute toward paying for the indirect (fixed) costs and later for profit.