Contribution Margin

In CVP analysis, a type of managerial accounting, the contribution margins are the management profit per unit.  It is a useful quantity for doing several computations and could be utilized as a measure of the operating leverage. Generally, high contribution margins are common in the labor-intensive tertiary sector while low contributions are common in capital-intensive industrial sector.

Contribution margin is especially useful because it provides insight into the profit potential of the company. Contribution margin is the excess of sales over variable costs, as shown below.

Contribution margin = sales – variable costs

Let us take an example and assume the following data for a business organization:

• Sales is 50,000 units
• Sales prices per unit is 20 dollars per unit
• Variable cost per unit is 12 dollars per unit
• Fixed costs is 300, 000 dollars

Sales (5,000 units x 20 dollars)………………………………………………1,000,000 dollars
Variable costs (50,000 units x 12 dollars)……………………600,000 
                                                  ________

Contribution margin (50,000 units x 8 dollars)……= 400,000 dollars
Fixed costs ……………………………………………………………………………………………………300, 000
                                                  ________

Income from operations……………………………………………………………………= 100,000

The company’s contribution margin of 400,000 dollars is available to cover the fixed costs of 300,000 dollars. Once the fixed costs are covered, any additional margin increases income from operations.  It is like pouring water in a bucket.  The bucket is the fixed cost and the water which is filling the bucket is the contribution margin. Once the bucket is filled, the overflow shows the income from the operations. Up until the point of overflow, the contribution margin contributes to fixed costs (filling the bucket).

Contribution Margin Ratio:

The contribution margin could also be expressed as a percentage. The contribution margin ratio is also known as profit-volume ratio, which shows the percentage of each the sales dollar available in order to provide income from the operations and to cover fixed costs.  

Contribution margin ratio = contribution margin/ sales

Questionnaire:

• What is contribution margin?
• Give the formula to calculate contribution margin?