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Contribution margin is an important method of not only understanding how profitable a business is, but also how its products and services contribute to the bottom line. It’s important to understand that contribution margin is different from profit margin, since profit margin measures the total amount of sales revenue minus costs. Instead, contribution margin measures the profitability of each individual product or service after subtracting variable costs.
Contribution Margin Definition
Although contribution margin can be interpreted and used in a number of ways, the basic definition of contribution margin is the revenue remaining from a particular product or service sale once total variable costs are subtracted.
Contribution Margin Formula
Contribution Margin = Unit Sales Price – Variable Costs
Contribution Margin Analysis
The contribution margin allows a business to evaluate which products and/or services are most valuable and profitable. This common financial analysis tool helps business owners and managers determine which product lines and services should be emphasized and which ones should receive fewer resources or be eliminated.
Business owners also find an analysis of the contribution margin useful in making pricing decisions such as deciding when to lower or increase prices in special situations, and in determining which products should receive more resources such as marketing budget. The contribution margin also helps determine the profits that may be expected at different sales levels.
Negative or very low contribution margins generally indicate that a product or service is not profitable, and presents an opportunity to re-evaluate that specific product or service. Often, this tool is useful in helping business owners decide when to discontinue a product line, or invest in research and development in an effort to increase its price or decrease the cost of production.
In the event the business is experiencing a bottleneck or other limitations in production capabilities, the contribution margin analysis allows business owners to determine which of its products and services have the highest profit margin, and therefore should benefit from the available resources.
Contribution Margin Ratio
The contribution margin ratio shows what percentage of each dollar of revenue goes towards covering fixed costs. This percentage can be calculated either on a per-unit or aggregate basis. The per unit basis divides the contribution margin per unit by the unit sales price, while the aggregate divides the total contribution margin by the total revenue.
Total Contribution Margin
The total contribution margin is the total earnings available to to pay for fixed expenses and generate profit across all products and services. This is different than the unit contribution margin, which specifically measures the contribution of an individual product or service, and the resulting incremental profit earned for each unit sold.