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Contribution Margin

By Yuriy Smirnov Ph.D.

Definition

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.

  1. When it is necessary to decide whether or not to sell additional products at a lower price.
  2. It helps to evaluate profitability at various level of business activity.
  3. The concept can be used to select the most profitable products. If a business is able to produce a variety of products but does not have enough resources to produce them all, products with a higher contribution margin are preferable.

Formula

Contribution Margin per Unit

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

Total Contribution Margin

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.

Contribution Margin Ratio

The contribution margin ratio can be calculated by using either of the two formulas below.

Contribution Margin Ratio =  Sales - Variable Costs
Sales

or

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
Sales

or

Contribution Margin Ratio =  Contribution Margin per Unit
Price per Unit

Please note that the contribution margin ratio can also be expressed as a percentage.

Graph

The relationship between total contribution margin and sales level is shown in the graph below.

Total contribution margin graph

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.

Contribution margin per unit graph

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.

Calculation Example

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.

Contribution margin calculation example