The contribution margin percentage, also known as the contribution margin or the contribution margin ratio, is a margin stated on a gross or per-unit basis.

The contribution margin is the selling price of any given unit minus the variable cost associated with the production of that unit.

In this case, contribution refers to the portion of a unit's sales that isn't eliminated by the variable cost of its production. After deducting the variable cost, what is left over contributes to paying the fixed costs associated with production.

With a contribution margin, an amount of money is generated for every unit sold after the variable costs for the unit's production are deducted. Business leaders use the contribution margin to tell them how much a product is contributing to the profits of a company.

At a glance, leaders can interpret the contribution margin to evaluate the profit potential of a product and determine how the product's sales can support the company with regard to covering fixed costs.

After the sale of a unit has its variable costs subtracted and its contribution deducted to account for fixed costs, whatever is left from the sale is recognized as the profit generated by the unit.

Contribution Margin Formula

Because the contribution margin ratio provides insight into the profit derived from the sale of products (or units), it is also known as the unit contribution margin. The equation for calculating this margin, in simplest terms, is:

  • Selling Revenue – Variable Cost = Contribution Margin

Contribution margin can also be calculated as a ratio. The equation for calculating the contribution margin ratio is:

  • Sales Revenue – Variable Costs / Sales Revenue = Contribution Margin Ratio

Business leaders use the contribution margin and ratio in several ways. However, an understanding of the difference between fixed and variable costs is necessary before trying to understand how contribution margin is calculated.

Fixed Costs Versus Variable Costs

When discussing costs to a business, fixed costs during the normal course of business do not change with increased or decreased sales volume while variable costs do.

Costs that are static, such as salary, are fixed costs, although they may become a smaller percentage of unit costs as more products are produced.

Costs for services and utilities that are not associated with the number of units sold are also considered fixed costs. For example, the rent for the manufacturing facility or office space for administrative personnel is a fixed cost.

Variable costs, on the other hand, change with the number of units produced and sold. If the use of electricity increases as more units are produced, then electricity is a variable cost. The money spent on the parts that make up a product also vary with the number of units produced.

Both variable and fixed costs are considered in the calculation of different types of margins, including contribution margins.

Meaning of a Contribution Margin

A break-even analysis helps an organization determine how much it needs to sell, either monthly or annually, to break even on the cost of doing business. Break-even analysis relies upon the contribution margin because it distinguishes between fixed costs and the profits that arise from a product's sales.

In calculating the break-even point, the fact that the profit can be distinguished before fixed costs are considered, lets business leaders know how much profit can be derived from the sale of the unit. The profits calculated can then be used to inform sales commission structures for those selling the unit.

Armed with an understanding of the difference between the amount going toward covering fixed costs versus actual profits, business leaders can set a price range within which the product remains profitable after covering those costs.

Information Provided by the Contribution Margin Ratio

The contribution margin ratio tells business leaders whether the product is creating enough money to cover both fixed expenses and administrative overhead so that a company breaks even. When the margin is low, it suggests that the price point of the product is too low and that the product will not generate enough profit over time to help the company break even.

There are times when a low contribution margin ratio is acceptable, such as during brief sales periods meant to generate interest in a product.

Sometimes, products are sold at a low contribution margin ratio when they are bundled with other products and services that are sold at a higher ratio to create a total bundle of products or services that have a positive ratio.

In practice, a simple example of the ratio occurs in the following manner after applying the contribution margin formula.

If $1,000 worth of sales occurs with $500 in variable expenses, the business is left with $500 to cover fixed expenses. If the fixed expenses for that period are $600, the company experiences a loss of $100. If the fixed expenses for that period are $400, the company experiences a profit of $100. In this example, because the company made $500 after subtracting variable costs, its ratio is 50 percent, or ($1,000 - $500) $1,000.

The higher the ratio, the more positive it is for a company because the products are generating additional revenue that can go toward covering fixed expenses. In this example, if variable costs are only $100, then the company makes $900 before paying off fixed costs and has a ratio of 90 percent.

Contribution margin ratios indicate whether a product's price needs to go up to cover fixed costs and generate more profit. By looking at the specific numbers, business leaders can tell whether they should increase the price to generate more profit or find ways to reduce the fixed costs that must be covered.

Contribution Versus Gross Margin

Contribution margin and gross margin differ in one significant way. When calculating gross margins, the fixed overhead costs are included, while contribution margins do not include the fixed overhead costs. Consequently, because the fixed overhead costs are not included in contribution margins, these margins are always higher than the gross margins.

Gross margins are calculated through a simple formula of revenue minus the cost of goods sold. However, the cost of goods sold requires calculating the variable and fixed costs of the product. Typically, several factors contribute regularly to the costs calculated in the gross margin, including the cost of direct materials, direct labor, and both variable and fixed overhead.

Variable overhead consists of overhead costs that change with increased sales, such as production supplies, while fixed costs, such as employee's salary, does not vary with increased sales.

Contribution margin consists of the costs accrued due to direct materials, variable overhead costs and commission expenses. Because the contribution margin depends on costs that fluctuate with sales, many other costs are excluded from the calculation of contribution margin, including fixed costs such as direct labor.

The number arrived at after all of those concerns are addressed is the contribution margin. After that amount is applied to covering fixed costs, the final number that results is the profit.