Contribution margin measures profit added by each sale, expressed as total contribution margin, unit contribution margin, or contribution margin ratio. It can show profitability of a product line and how sales affect overall profits. Limitations include inconsistent per-unit production costs.
Contribution margin measures the amount of total profit added by each sale. That’s the difference the sale makes; it is also possible that the change made is to reduce losses rather than increase profits. The value can also be negative, meaning that each sale reduces overall profits, although this is a sign of a serious problem with the business setup.
The figure can be expressed in three different ways. Total contribution margin is total revenue minus variable costs. Variable costs are those associated specifically with production and therefore may include the cost of raw materials; they don’t include fixed costs like factory rent. Total contribution margin therefore shows how much is left over from sales to help offset and hopefully exceed fixed costs.
The unit contribution margin measures unit revenue minus variable cost per unit. In other words, it is the amount the company receives for each unit sold, minus the specific costs associated with producing that unit. The value the company receives will not necessarily be the price the end user pays, as the product may pass through a retailer. The unit contribution margin can thus show how profitable a specific product line is. It can also show how the level by which sales would have to increase to have a specific effect on the company’s overall profits.
The contribution margin ratio is the unit contribution margin divided by the unit price. By definition, the same number can be calculated by dividing the total contribution margin by the total revenue. The figure effectively shows what proportion of the selling price is left after variable costs to cover fixed costs and eventually make a profit.
The most common way to display the concept is in a graph that shows how increasing sales affects overall profitability. Every sale adds some profit to the company. Naturally, initially these sales are not enough to cover fixed costs and the company will be in a loss-making position. As the number of sales increases, eventually sales profits cover fixed costs and the business breaks even. After that point, increased sales add to overall profits.
There are some limitations in using the concept in calculations. Most significantly, it works on the assumption that per-unit production costs are consistent. In practice, the more units a company produces, the lower the variable costs per unit. This is due to economies of scale, such as getting discounts on raw materials when purchased in bulk.
Asset Smart.
Protect your devices with Threat Protection by NordVPN
