What is the Contribution Margin?
The contribution margin (C.M.) is the amount of revenue in excess of variable costs. To cover the company’s fixed cost, this portion of the revenue is available. And after all fixed costs have been covered, this provides an operating profit.
Hence contribution is a profit measure, although an incomplete one, since fixed costs are not covered. However, when the contribution margin is expressed as a ratio or as a percentage of sales, it provides a sound alternative to the profit ratio.
The difference between the selling price and variable cost is a contribution, which may also be known as gross margin. Variable cost refers to the marginal cost. In fact, both are synonymous. The contribution margin may also be expressed as fixed costs plus the amount of profit.
In other words, we can say that:
- Profit will be there only when the fixed cost(s) is less than the contribution.
- If the contribution is more than the fixed cost(s) the result will be a loss.
- When the contribution is equal to the fixed cost(s) the point of no profit and no loss is indicated, which is termed as Break-even Point.
Formula to calculate the contribution margin
The following formula can be used to calculate the contribution margin:
Contribution Margin = Sales revenue – Variable expenses
Contribution margin = Fixed Cost + Profit
Let’s explain this formula with the help of the following example:
Assume that company X manufactures and sells a single product. The various per unit costs are:
Unit S.P. = $25
Unit V.C. = $15
Unit Contribution Margin = $10
Total fixed costs are $30,000 for the time period involved. Presently, the sales of the company are 1,00,000.
The different formula’s for calculating the break-even point (B.E.) point are:
For the above question, the calculations are as under:
(i). Break-even point in sales units
B.E Point = 30,000 / 10 = 3,000 units
(ii). Break-even Point in Sales Percentage
Selling price per unit = $25 (100%)
Variable cost per unit = $15 (60)
Contribution Margin per unit = $10 (40%)
Break-even point in sales ($)
= 30,000 / 40% = $75,000
The break-even point in Sales ($) can also be expressed as:
S.P. per unit x B.E. Point in units
25 x 3,000 = $75,000
Each unit sold contributes $10 to cover fixed costs and profits. The Break-Even point for company X is 3,000 units. If the company realizes a level of activity of more than 3,000 units, a profit will result, if less, a loss will be incurred. Profits will equal the number of units sold in excess of 3,000 units multiplied by the unit contribution margin. Thus at the 5,000 unit level, there is a profit of $20,000 (2,000 units above break-even point x $10).