The contribution margin (CM) is an accounting concept used in cost-volume-profit analysis to estimate the profitability of a specific product or service. It can be defined as per unit amount, total amount, ratio, or percentage.
This concept is very useful in various management decisions.
The per unit amount is the difference between the sales price of a unit and the variable cost per unit.
Contribution Margin per Unit = Price per Unit - Variable Cost per Unit
The total contribution margin is the difference between sales and total variable costs.
Total Contribution Margin = Sales - Variable Costs
In other words, it is an amount by which sales exceed the total variable costs of a business.
The contribution margin ratio can be calculated by using either of the two formulas below.
|Contribution Margin Ratio =||Sales - Variable Costs|
|Contribution Margin Ratio =||Price per Unit - Variable Costs per Unit|
|Price per Unit|
The formulas above can be written as follows:
|Contribution Margin Ratio =||Total Contribution Margin|
|Contribution Margin Ratio =||Contribution Margin per Unit|
|Price per Unit|
Please note that the contribution margin ratio can also be expressed as a percentage.
The relationship between total contribution margin and sales level is shown in the graph below.
As far as sales revenue and total variable costs are in direct proportion with the level of business activity, the value of the total contribution margin is rising as sales increase.
In contrast, the contribution margin per unit remains constant at any level of business activity until any change in sales price and/or variable cost per unit. Its behavior is shown in the graph below.
However, the contribution margin can also have a negative value in some special situations, which means that sales revenue generated by a specific product does not even cover the variable costs incurred to manufacture it. If the special situation continues, a business should stop manufacuring and selling such a product.
Xander Fashion LLC is a clothing store with four main products. The data for sales price, variable cost per unit, and number of units sold in the last quarter are shown in the table below.
Let’s perform a contribution margin analysis using the formulas mentioned above.
CM per Unit Jeans = $85 - $50 = $35
CM per Unit Pants = $50 - $25 = $25
CM per Unit T-Shirts = $45 - $30 = $15
CM per Unit Sweaters = $90 - $60 = $30
Sales Jeans = $85 × 2,500 = $212,500
Sales Pants = $50 × 1,700 = $85,000
Sales T-Shirts = $45 × 3,250 = $146,250
Sales Sweaters = $90 × 1,300 = $117,000
Total Variable Costs Jeans = $50 × 2,500 = $125,000
Total Variable Costs Pants = $25 × 1,700 = $42,500
Total Variable Costs T-Shirts = $30 × 3,250 = $97,500
Total Variable Costs Sweaters = $60 × 1,300 = $78,000
Total CM Jeans = $212,500 - $125,000 = $87,500
Total CM Pants = $85,000 - $42,500 = $42,500
Total CM T-Shirts = $146,250 - $97,500 = $48,750
Total CM Sweaters = $117,000 - $78,000 = $39,000
CM Ratio Jeans = $87,500 ÷ $212,500 = 0.412 or 41.2%
CM Ratio Pants = $42,500 ÷ $85,000 = 0.500 or 50.0%
CM Ratio T-Shirts = $48,750 ÷ $146,250 = 0.333 or 33.3%
CM Ratio Sweaters = $39,000 ÷ $117,000 = 0.333 or 33.3%
The results of contribution margin analysis are summarized in the table below.