What Is Contribution Margin?
Contribution margin is a business accounting term that measures the difference between sales revenue and the variable costs to produce or sell a product. It shows the amount of profitability a company would achieve once it covers its fixed costs, i.e., its breakeven point.
A company's fixed costs remain basically the same whether it makes or sells one unit or thousands. The most common fixed costs are rent and the costs associated with keeping a store or factory open. For example, a grocery store's fixed costs would include the building, keeping the lights and refrigerators on, and so forth.
A company's variable costs change depending on how many products or sales it makes. For example, a computer manufacturer's costs for labour, components, shipping, and the like would rise the more computers it sells.
How Is A Contribution Margin Calculated?
The contribution margin is calculated simply as such: Contribution margin = Sales revenue – variable costs
To express it as a ratio, simply divide that figure by total sales, as such: Contribution margin ratio = Sales revenue – variable costs/Sales revenue
Companies can calculate these figures for the entire company or division or on a per unit basis. For example, if a company sells a computer for US$500 and the variable cost to produce one is US$300, the contribution margin would be $200. That amount of money would be used to contribute—hence the name—to the company's fixed costs and, ultimately, profitability.
Generally speaking, companies in labour-intensive industries, such as apparel manufacturers, would have relatively low contribution ratios. They have to hire more workers and buy more material the more clothes they sell. As a result, their profitability doesn't necessarily rise along with sales.
By contrast, capital-intensive, industrial companies with high fixed costs, such as automobile manufacturers, would have high contribution margins. Their profits would rise once their sales exceed the break-even point on fixed costs. It is therefore preferable to have high contribution margins, assuming of course that sales go up, because profitability would rise with revenue.
Contribution margin is a business accounting term that measures the difference between sales revenue and the variable costs to produce or sell a product. It shows the amount of profits a company would achieve once it covers its fixed costs, i.e., its breakeven point.