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Contribution Margin

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.

Summary

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.

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