The Importance of a Contribution Margin
The contribution margin reflects a company's profitability on each unit sold. To calculate the contribution margin, variable expenses are subtracted from revenue for each unit, or for product sales in total. Variable expenses are those costs that increase or decrease with production or output.
If a company produces nothing, its variable costs will be zero.
Companies calculate contribution margins for a single product, multiple groups of products or for their entire product line. A contribution margin is important because it shows how much money is available to pay the fixed costs such as rent and utilities, that must be paid even when production or output is zero.
A company can calculate an overall contribution margin and a contribution margin per unit. While the contribution margin shows how much revenue is left over after variable expenses, the contribution margin per unit shows how much profits will increase with the sale of each unit.
Profits increase with incremental production levels once a company sells enough product to meet its variable expenses.
Factor in Fixed Costs
A business will incur costs that it cannot trace to the production or sale of a product. These costs are known as fixed costs and occur even when the company does not produce any product(s). Common examples of fixed costs include rent and insurance. The contribution margin must also cover these types of costs in order for a business to achieve and maintain profitability.
If the contribution margin does not exceed a company's fixed expenses, it does not make a profit. A company that has a contribution margin that is less than its fixed expenses incurs a loss.
The contribution margin often helps a company decide whether it should manipulate its selling price and sales volume. Some of the ways a company can increase a contribution margin is by reducing fixed costs, increasing the sales price or increasing sales of units with the highest contribution margin.
A higher contribution margin usually means that a business is able to spend more on advertising to increase its sales volume. Lower contribution margins might mean that a company will have to rely on less-expensive forms of promotion, such as publicity and customer referrals.
A contribution margin analysis shows how much of a product a company should sell.
Let's assume a company makes printers with a $10 unit contribution margin and has $10,000 in fixed expenses. The company would need to sell 1,000 printers to break even.
If the company wants to make a profit of $50,000, it would need to sell 6,000 printers. In short, a contribution margin analysis helps a company figure out how to reach its profitability goals.