The contribution margin is the amount by which the selling price of a product exceeds its total variable unit costs.
This difference between the selling price and the variable cost per unit is known as the contribution margin, as it represents the per-unit contribution towards paying fixed costs.
Therefore, the contribution margin is initially used to pay fixed expenses, and whatever is left after fixed expenses are recovered is allocated to profits. The period incurs a loss if the contribution margin is insufficient to meet the fixed expenditures.
For example, the sales revenue from one shirt is $15 and the variable cost of one shirt is $10, so the individual contribution margin is $5. This $5 contribution margin is assumed first to cover fixed costs first and then realised as profit.
Where is Contribution Margin Used?
Many internal decisions are based on the contribution margin income statement. This is because expenses are grouped by behaviour as opposed to function, which gives superior internal information. You may recall that the definition of contribution margin is revenues minus variable expenses. Revenues minus variable expenses equal the contribution margin on an income statement. We deduct fixed costs to arrive at operational income. When the contribution margin equals fixed expenses, there is no operational income.
How to Calculate Contribution Margin?
Let’s say the selling price per unit is $15, the variable cost per unit is $10 and the fixed cost is $150,000. Here the contribution per unit will be $5 (i.e. selling price – variable cost; $15-$10). $150,000 is the contribution for $30,000 units ($150,000/$5). It is sufficient to meet the fixed costs of $150,000 but no margin for profits is left.
There are many alternatives to computing the contribution margin. We can use and apply any of the given three formulae. The result will be the same:
Contribution = Selling Price – Marginal Cost
For example, if the selling price per unit is $10 and Variable Costs are worth $7, the contribution margin will be $3. This $3 includes the fixed cost per unit + the profit per unit.
Contribution = Fixed Expenses + Profit/(Loss)
If noticed carefully, it is just a change in the equation. Here also the contribution margin is the sum of fixed costs along with profit or loss.
Contribution – Fixed Expenses = Profit/(Loss)
It is again, nothing more than a change in the equation. However, using this formula, we get the profit or loss value and assume that we have already computed the contribution margin.
In marginal costing, the contribution is very important as it helps to determine the profitability of a product, department or division, to have a better mix of the products or for better profit planning.
Here it needs to be understood that the contribution margin is not the profit, and it is different from the profit. The profit or surplus is the net gain and is arrived at after deducting fixed costs/expenses from the total contribution. Cost accountants find the contribution margin as the true representative of actual profit.
Unit Contribution Margin
When the contribution margin is calculated on a per unit basis, it is referred to as the contribution margin per unit or unit contribution margin. You can find the contribution margin per unit using the equation shown below.
This unit contribution margin can be calculated either in dollars or as a percentage, which is crucial to remember.