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Contribution Margin (Explained: All You Need To Know)

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What is a contribution margin?

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Let me explain to you what contribution margin means and why it matters!

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What Is Contribution Margin

Contribution margin is an accounting term used to refer to the incremental cash generated by taking into consideration the company’s variable costs.

In many cases, contribution margins are stated on a per-product or per-unit basis.

You can consider the contribution margin as how much a unit or product contributes to the overall profitability of the company.

Once you determine your contribution margin, you can then deduct your company’s fixed costs to determine the potential profit that may be generated by the products or units sold.

Companies that have capital-intensive operations and high fixed costs will need to have higher contribution margins to be able to pay for such fixed costs.

On the other hand, companies that are labor-intensive and do not have a lot of fixed costs will have lower contribution margins.

Keep reading as I will further break down the notion of contribution margin.

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Why Is Contribution Margin Important

The contribution margin is important for companies to determine as it’s the difference between the sales price per unit and the variable costs associated with the unit production.

You can consider the contribution margin to be the money you have left over after having paid for the variable costs for producing your units to pay for your fixed costs.

Companies that have a lot of equipment, machinery, and fixed costs will need to have a higher contribution margin to be able to pay for their fixed costs.

When a company does not properly determine its contribution margin, it may not generate enough money to keep the business in sustainable operations.

In essence, the contribution margin is important when performing a break-even analysis when evaluating your unit sales price and production costs.

When you separate your fixed costs from your variable costs, you can then properly set your price per unit, determine how much you can afford to pay in commissions, and how many units you must sell to break even.

In addition, companies can evaluate the contribution margin for producing different types of goods using the same manufacturing resources.

When there are competing products that could be made, the company should prioritize the products that have greater profit potential.

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Contribution Margin Formula

The contribution margin formula can be presented as follows:

Contribution Margin = Sale Price Per Unit – Variable Costs Per Unit
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As you can see, the contribution margin provides you with the difference between the sales price per unit and the variable costs in producing that unit.

The result represents the amount of money the company has available, per unit, to pay for its fixed costs.

The contribution margin formula is commonly used to perform different types of break-even analysis.

Companies that have to make operational decisions can look at the contribution margin for their different products and choose to invest further in the products that generate the most profits.

You can also calculate the contribution margin using the following formula:

Contribution Margin = Fixed Costs + Net Income
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Or 

Contribution Margin = Net Sales – Variable Costs
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Contribution Margin Components

The contribution margin consists of the sales price less variable costs, giving you the money left over to pay for your fixed costs.

As such, you have the notion of sales price, variable costs, and fixed costs.

The sales price represents the price at which the company sells every unit.

For instance, a company producing automobile tires will need to calculate what would be the appropriate price for its tires so that it can sustainably generate profits.

The variable costs represent the costs that vary based on production levels.

For example, a car tire company will need more raw materials to produce more tires.

To produce more tires, you need to consume more electricity and other types of resources.

These costs vary as a function of the company’s output.

Then, you have the fixed costs.

Fixed costs are those costs that remain the same no matter the production levels.

For example, an auto tire company will have to pay for its production plant and machinery no matter how many units it produces.

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Contribution Margin Example

Let’s look at an example of contribution margin to better understand the concept.

Let’s assume that a company produces canned soup.

The company needs to purchase the ingredients to make the canned soup and must then produce the cans.

The all the soup ingredients cost the company $1.00 per can.

In the production process, the company’s electricity and labor costs also vary based on production levels.

For every can, the company’s electricity cost is $0.10 and $0.50 labor costs.

As a result, the company’s total variable costs per can is $1.60.

However, the company has to pay the fixed costs for operating its production plant. 

The company’s fixed cost is $2 million per year.

No matter how many cans are produced, the company’s current fixed costs remain at $2 million.

If the company produces 10,000 cans, it will have variable costs of $16,000 and fixed costs of $2,000,000 ($201.6 cost per can).

If it sells 100,000 cans, it will have variable costs of $160,000 and fixed costs of $2,000,000 ($21.60 per can).

If it sells 1,000,000 cans, it will have variable costs of $1,600,000 and fixed costs of $2,000,000 ($3.60 per can).

As you can see, depending on the company’s production level, its contribution margin can change.

The more a company is able to produce its canned soups using its current machinery and production plant, the more it can reduce its costs per unit.

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Contribution Margin FAQ

What does contribution margin mean?

The “contribution margin” is the selling price per unit less the variable cost per unit.

In other words, the term “contribution” refers to the portion of the sales revenues that are not consumed to produce the goods and can be allocated to cover fixed costs.

This is a key concept in developing break-even analysis models.

What is the difference between contribution margin and profit margin?

The contribution margin refers to the amount of money a company generates per unit after it has paid for the variable costs associated with the production of that unit.

On the other hand, the profit margin is how much the company generates after it has paid for all direct production costs.

What are examples of variable costs?

Examples of a company’s variable costs are:

  • Direct materials
  • Production supplies
  • Labor costs
  • Commissions
  • Transportation costs
  • Freight costs
  • Utilities 

What are examples of fixed costs?

Examples of a company’s fixed costs are:

  • Depreciation costs
  • Interest expenses
  • Insurance premiums 
  • Rent
  • Property taxes
  • Salaries 
  • Fixed utilities 

Takeaways 

So there you have it folks!

What does “contribution margin” mean?

In a nutshell, contribution margin can be defined as a company’s sales revenues less its variable costs.

A company uses its contribution margin to pay for its fixed costs and other remaining expenses.

Then, whatever is left over is the company’s net profit.

Typically, contribution margins are presented in percentage or in dollar figures.

It can be presented by unit, by department, by product, or as a percentage of net sales.

Companies evaluate their products’ contribution margins to decide which products to sell using the same manufacturing resources, at what price to sell on a per-unit basis, or how much to produce to break even.

The higher a company’s contribution margin for a product, the better the economic benefit of selling or producing that product.

Now that you know what is a contribution margin and how it works, good luck with your research!

Profit margin
Absorption cost
Variable cost
Fixed cost
Marginal costs
Marginal benefit
Fixed cost vs variable cost
Sensitivity analysis 
Break-even analysis
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Hello Nation! I'm a lawyer by trade and an entrepreneur by spirit. I specialize in law, business, marketing, and technology (and love it!). I'm an expert SEO and content marketer where I deeply enjoy writing content in highly competitive fields. On this blog, I share my experiences, knowledge, and provide you with golden nuggets of useful information. Enjoy!

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