Contribution Margin: Definition, Overview, and How To Calculate 2024

Variable costs tend to represent expenses such as materials, shipping, and marketing, Companies can reduce these costs by identifying alternatives, such as using cheaper materials or alternative shipping providers. If you’re targeting growth and market share, you may sacrifice contribution margin for customer acquisition. A common mistake would be assuming that you should cut your lowest-contribution-margin products. You must consider your wider portfolio of products and how this will impact customers. For example, suppose a company hires ten extra workers, just for two months, to increase the production of a product during a period of high demand.

To demonstrate this principle, let’s consider the costs and revenues of Hicks Manufacturing, a small company that manufactures and sells birdbaths to specialty retailers. If all variable and fixed costs are covered by the selling price, the breakeven point is reached, and any remaining amount is profit. From this calculation, ABC Widgets learns that 70 percent of each product sale is available to contribute toward the $31,000 of total fixed expenses it needs to cover each month and also help achieve its profit target. Next, you want to calculate the contribution margin of the same boutique’s sundresses. The dresses create more revenue and result in about $35,000 in annual revenue (or 1,000 dresses for $35 each).

Decision Making and the Contribution Margin

Contribution margin is used most often by companies to help them determine which products are most profitable. Using this information, they can determine which products to keep and which to stop producing. They also may use contribution margin to make pricing decisions, as a low contribution margin might indicate the company needs to raise its prices.

Fixed costs include periodic fixed expenses for facilities rent, equipment leases, insurance, utilities, general & administrative (G&A) expenses, research & development (R&D), and depreciation of equipment. Companies often look at the minimum price at which a product could sell to cover basic, fixed expenses of the business. They include building rent, property taxes, business insurance, and other costs the company pays, regardless of whether it produces any units of product for sale.

Total Contribution Margin

However, you have to remember that you need the $20,000 machine to make all those cups as well. You may need to use the contribution margin formula for your company’s net income statements, net sales or net profit sheets, gross margin, cash flow, and other financial statements or financial ratios. In a business scenario, contribution margin, which represents the profitability a very low contribution margin is indicative of for each item sold after deducting variable costs, plays an important role in determining the overall profitability of a company. Profitability, in turn, provides resources that could be invested in socially responsible activities. In conclusion, understanding the dynamics of variable and fixed costs can give businesses an effective tool in enhancing profitability.

The company will use this “margin” to cover fixed expenses and hopefully to provide a profit. In our example, if the students sold \(100\) shirts, assuming an individual variable cost per shirt of \(\$10\), the total variable costs would be \(\$1,000\) (\(100 × \$10\)). If they sold \(250\) shirts, again assuming an individual variable cost per shirt of \(\$10\), then the total variable costs would \(\$2,500 (250 × \$10)\). More specifically, using contribution margin, your business can make new product decisions, properly price products, and discontinue selling unprofitable products that don’t at least cover variable costs. The business can also use its contribution margin analysis to set sales commissions. Contribution margin, gross margin, and profit are different profitability measures of revenues over costs.

How Companies Use Contribution Margin

Regardless of how contribution margin is expressed, it provides critical information for managers. Understanding how each product, good, or service contributes to the organization’s profitability allows managers to make decisions such as which product lines they should expand or which might be discontinued. When allocating scarce resources, the contribution margin will help them focus on those products or services with the highest margin, thereby maximizing profits. It is important to note that this unit contribution margin can be calculated either in dollars or as a percentage.

Allocating the expense of the temporary workers as either a fixed or variable cost would change the value of the contribution margin. Investors use many different indicators and thoroughly examine a company’s financials before deciding to invest in a company. The contribution margin of a company’s product lines is one particular factor investors may look at when researching a company. Usually, the products with the higher contribution margin will be allocated more resources because they will produce greater profits than if the same resources were used for the lower contribution margin product. The contribution margin ratio for the company was 60% (contribution margin of $480,000 divided by revenues of $800,000). Similar to contribution margin, a good gross margin highly depends on the company, industry, and and product.

How can you use contribution margin?

At the same time, the cost of the ingredients, hourly wages, and equipment used to make the food comes to $500,000—that’s the cost of goods sold. Investors and analysts use the contribution margin to evaluate how efficient the company is at making profits. For example, analysts can calculate the margin per unit sold and use forecast estimates for the upcoming year to calculate the forecasted profit of the company. This is the net amount that the company expects to receive from its total sales. Some income statements report net sales as the only sales figure, while others actually report total sales and make deductions for returns and allowances. Very low or negative contribution margin values indicate economically nonviable products whose manufacturing and sales eat up a large portion of the revenues.