Contribution Margin: Formula and Analysis

Contribution margin is the measurement through which companies can understand how the net sales of companies will contribute to fixed expenses and net profit after covering variable expenses.

In this article on contribution margin, we will be discussing its formula and importance. We will also discuss the ways to increase this margin.

Table of Contents

• What is contribution margin?
• Formula
• How to increase the margin?
• Contribution margin analysis

What is Contribution Margin (CM)?

The contribution margin is known as the selling price per unit reduced from the variable cost per unit. It is the money remaining from sales once all variable expenses associated with producing a product are paid. 

This measure indicates how a specific product contributes to the overall profit of a company. This margin offers a method to show profit potential of a particular product offered by the company. It also shows the portion of sales that helps in covering the fixed costs of a company. 

In management accounting, as per the cost-volume-profit analysis, the marginal profit per unit sale is useful in carrying out various calculations. These can be used as m measure of operating leverage.

The difference between Contribution and Gross Margin is in terms of the formula. The gross margin metric is calculated as the gross profit divided by revenue. This measures the amount or revenue remaining; after all, direct costs have been subtracted. In this margin, the calculation is similar to the gross margin. However, it can be analyzed more in-depth on a per-item/per-product profitability level.

Formula For Contribution Margin

The formula is computed using the following formula:

Contribution Margin = Total Revenue – Variable Costs

Using this formula, one can express this margin as the fraction of total revenue. 

Another formula that helps in calculating Contribution Margin Ratio (CR). It is the ratio of contribution margin divided by total revenues in the same time period. 

CR = Contribution Margin / Total Revenues

Importance

The contribution margin is the foundation for the break-even analysis that is used in overall cost and sales price planning for products. It helps in separating out fixed cost and profit components that come from product sales and can be utilized for determining the selling price range of a product.

Let us consider that manufacturing chairs cost around $50000. One chair’s manufacturing cost is worth $500 inclusive of all the raw materials. While manufacturing the chair, $10 goes into the electricity bill, $15 goes into raw materials, and $20 goes as labour charge. These three components constitute for the variable cost per unit. If a total of 100 chairs are manufactured, then the variable cost is $500. 

This margin helps businesses in selecting among several options that compete to use the same set of manufacturing resources. In case a company has a chair manufacturing machine, then the company should choose to only produce plastic chairs.  

Ways To Increase Contribution Margin

There are two methods that companies have for increasing the margin. Either they can reduce the variable cost or they can work towards increasing revenue. 

• To reduce the variable cost, companies can identify alternatives such as finding cheaper raw material vendors or less expensive materials.
• Another method is to find methods for improving revenues. They can do cost-cutting, increase their customer base or increase the prices of their products.

It is important to wisely implement these strategies since they might result in lower margins.

Contribution Margin Analysis

Such analysis helps in determining if a company uses its revenue effectively. A high margin indicates that the company brings in more money than it spends. If the margin values are very low, it indicates economically non-viable products whose manufacturing and sales consume a larger portion of revenues. Low contribution margins are usually observed in the labour-intensive industry sectors. High contribution margins are more prevalent in capital-intensive sectors.