What is the Contribution Margin?
Contribution margin measures the profitability of a product by subtracting its variable costs from its sales price to reveal what’s leftover for fixed costs and realized profit.
A contribution margin is a product’s sales price, minus the total variable expenses –- Variable expenses are the costs needed to make a product. Contribution margin tells companies how much is left over to pay fixed costs (costs that don’t change with production, like rent) before taking profits. A company’s contribution margin is a key metric in analyzing price points and volume as well as product performance. A product with a high contribution margin means it’s more profitable. A product with a low contribution margin may not be able to pay fixed per-unit costs and generate a profit. Contribution margins can give investors insights into a company’s product performance and profit-generating ability, which is helpful when analyzing the financial strength and longevity of a company.
To manufacture a product, you probably need a factory. Whether you make two products or two million products, the lease price of the factory won’t change. Its cost is fixed. But the cost of the materials you need to make the products will change –- Those costs are variable. The more products you make, the more stuff you need to buy. Ultimately, you want the sales of your products to take care of the costs to make the products. But will the sales be enough to pay for your lease and give you a profit as well? A contribution margin will tell you. It subtracts the material costs from the product sales so you can see how much you have leftover to pay for your factory and put back into your bank account.
Say you make widgets, and you sell each for $4, while it costs you $3 in variable costs for each one.
$4 (Sales Revenue) – $3 (Variable Costs) = $1 (Contribution Margin)
The widget has a positive contribution margin of $1.
A contribution margin tells you how much your cookie sales bring in after you pay for your cookie dough…
The more cookies you make, the more dough you need to buy. Cookie dough varies with cookie amounts. If you’re still making payments on your cookie oven, you’ll want to know how much money is left from your cookie sales after you pay for the dough so you can make that oven payment and still put some cash in your pocket.
The contribution margin (CM) of a product is its price minus the total variable costs (raw materials and labor) needed to make the product. CM tells you how much money is available after accounting for variable costs to pay for fixed costs (such as rent and utilities) and realize a profit.
Products will not make a profit unless they can pay for both variable and fixed costs — anything left over is profit. If a contribution margin is too low to cover fixed costs, a company will experience an operating loss. Companies can calculate the contribution margin of total sales minus total variable costs. Or they can look at the per-unit price less per-unit variable cost. Then they can determine how much an increase in product sales will increase profit, or whether they need to increase the sales price to make a profit.
In cost-volume-profit analysis, the contribution margin reveals appropriate product price points and sales volumes necessary to pay for variable and fixed costs and still make a profit. CM can also tell companies which products they make are the most profitable.
If a company releases a contribution margin income statement, investors can observe the contribution margin of a company’s most profitable product and compare it with competitors’ products to see how it stands up in the marketplace. If a competitor’s product is threatening the most profitable product of a company, the profitability of that company as a whole may be affected. Similarly, if investors notice that a company is discontinuing a product with a high contribution margin, they may be able to make some inferences about that company’s stability.
Gross margin reflects the amount remaining after the Cost of Goods Sold (COGS) is subtracted from total sales or revenue. COGS is all of the direct costs required to make a product, including the variable costs needed to buy the materials for the product, but it can also include fixed costs such as factory overhead.
Fixed costs don’t vary, no matter how many products you produce. Fixed costs are costs for things like leases, staff salaries, and utilities — anything you have to pay for, whether or not you produce more of a product, is a fixed cost. But variable costs only exist because of the creation of a product. Variable costs increase with the production levels of a particular product.
If you start a new product line, any additional raw materials, labor hours, or other expenses needed to produce the new product, will be variable costs — because they vary with production levels. Companies calculate the contribution margin on contribution margin statements (but they are often separated out on income statements as well). The contribution margin is the amount left over when only the variable costs are subtracted from the total amount of sales or revenue.
To calculate the contribution margin, you subtract total variable costs from total sales or revenues, or per-unit variable cost from the individual product price.
For example, if a product’s selling price is $20 and its unit variable cost is $5, its contribution margin is $15.
Once you’ve found the contribution margin, you can calculate the contribution margin ratio. The contribution margin ratio gives the difference between a product’s total sales, and its variable costs expressed as a percentage. You find the contribution margin ratio by dividing the contribution margin by total sales or revenues.
For a selling price of $20 and a unit variable cost of $5, we can figure a contribution margin ratio of $15/$20 = 75%. To get an idea of contribution margin and contribution margin ratio in action, let’s take a look at the income statement of the imaginary company Scootie’s Electric Skateboards.
On the left, we see Scootie’s income statement. On the right, see Scootie’s Contribution Margin Income Statement. Notice a few things about these statements:
The Contribution Margin Income Statement doesn’t change the COGS or operating expenses. It just organizes them in a different way to make it easier to see the amount of sales leftover that can cover fixed costs and realize a profit.
Scootie did fairly well. His contribution ratio says that for every dollar in sales, he has $0.80 leftover to cover his fixed costs and take profits. (160,000/200,000 = 16/20 = 8/10)
The contribution margin ratio represents the percentage of a product’s sales price that is available to pay for fixed costs and deliver a profit. Expressed as a percentage, the contribution ratio says, “for every dollar sold, X% is available to pay fixed costs and be realized as profit.”
A low contribution ratio suggests several things. If a company has low variable costs and believes it has the right product, perhaps it needs to focus on driving sales volume to be able to meet its fixed costs and hopefully make a profit. If it has high variable costs, it may need to adjust its pricing to meet expenses, or source less expensive materials to lower variable costs.
The contribution margin is an essential metric used in cost-volume-profit analysis. There are many contribution margin calculations a company can perform to answer questions about production and pricing using the contribution margin. A typical formula to perform equations in cost-volume-profit analysis is:
SPX - VC X - TFC = Profit
We can plug the contribution margin ratio into the cost-volume-profit analysis to answer questions for Greg, who owns the fictitious pizzeria Greg’s Pizza Place. For example, let’s perform a break-even analysis so Greg knows how much he needs to make so he doesn’t operate at a loss.
Greg is selling gourmet pizzas for $15 each. HIs total fixed costs are $20,000 per year. How many pizzas does Greg need to sell to break even if the variable cost ratio is 50% per pizza?
Imagine Greg’s been doing well and wants to expand. He wants to lease another pizza shop which will raise his total fixed costs to $50,000. Greg's also set a goal to take in profits of $75,000. Now, how many pizzas does he have to sell?
Suppose Greg’s total variable costs have increased to $10 per pizza because of a pepperoni shortage. And the lease on his first pizzeria has also increased to $30,000, which increases his total fixed costs to $60,000. But Greg is operating at full capacity. He can’t produce any more pizzas, so he needs to raise prices. What price should he choose for his pizzas to continue to bring in $75,000 in profit?
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