Jul 23

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Contribution Margin Definition

See Also:
Margin vs Markup
Segment Margin
Marginal Costs
Segmenting Customers for Profit
Financial Ratios

Contribution Margin Definition

Contribution margin (CM), defined as selling price minus variable cost, is a measure of the ability of a company to cover variable costs with revenue. The amount leftover, the contribution, covers fixed costs or is profit.

Contribution Margin Meaning

Contribution margin means a measurement of the profitability of a product. In addition, express it as a dollar amount per unit or as a ratio. CM can be calculated for a product line using total revenues and total variable costs. It can also be calculated at the unit level by using unit sales price and unit variable cost. The metric is commonly used in cost-volume-profit analysis and break-even analysis.

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Contribution Margin Formula and Contribution Margin Ratio Formula

Use the following contribution margin formula below:

CM = Unit Price – Unit Variable Cost

The contribution margin ratio, or contribution margin percentage, is the CM expressed as a percentage of the unit sales price. Calculate it using the following formula:

CM Ratio = (Unit Price – Unit Variable Cost) / Unit Price

Contribution Margin Calculation

After you collect all the information, it is fairly easy to calculate CM. For example, a company has a $1,000 unit price and a $150 unit variable cost

Contribution margin per unit= $1,000 – $150 = $850

Contribution Margin Ratio Calculation

The contribution margin equation can also be applied to create a ratio for the given values. For example, a company has a $1,000 unit price and a $150 unit variable cost

CM = ($1,000 – $150) / $1,000 = .85

Contribution Margin: Income Statement

The CM format income statement is a variation on the standard income statement that separates variable costs and fixed costs. It starts with revenues, subtracts variable costs, and then displays the CM, as well as, the CM percentage before subtracting fixed costs and giving the net operating income. A simplified CM format income statement might look like the following:

Revenue					        $100,000

Variable costs
	Raw material		$15,000
	Variable labor		$20,000
	Delivery charge	        $5,000
Total variable costs				$40,000
Contribution margin				$60,000
Contribution margin percentage		          60%

Fixed costs
	Rent			$25,000
	Utilities               $5,000
	Wages			$20,000
Total fixed costs                               $50,000
Net operating income				$10,000

Contribution Margin Example

For example, Isabel is the CFO of a private company, the holding company for a series of retirement homes, called Retireco. She has known the owner of Retireco since she was a child, noticing her unique drive to make her company a success. Isabel has turned her family friend into a lifelong business connection and now, having earned her expertise in the accounting world, is her CFO.

One day the CEO of Retireco asks Isabel to calculate the CM of her company. Her purpose is to know variable costs, fixed costs, and finally profit are derived from sales. Since she is familiar with it, this is a simple task.

Isabel begins by collecting all of the company financial records. Once she has done this, she sits down to perform CM analysis. Here, she finds a per unit value:

$1,000 unit price and a $150 unit variable cost

CM = $1,000 – $150 = $850

Isabel then converts this number to CM ratio:

$1,000 unit price and a $150 unit variable cost

CM = ($1,000 – $150) / $1,000 = .85

Isabel now knows that 85% of sales can move on to cover fixed costs or become company profits. Therefore, she can provide this information to the Retireco CEO with suggestions for how to best use this money for these purposes. By having effective financial ratios, doors open which can lead to further growth of Isabel’s career and the company as a whole. Want to check if your unit economics are sound?  Download your free guide here.

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