Contribution Margin model

A contribution margin is a cost accounting concept and it allows a company to determine the profitability of individual products. Contribution margin is the price at which a firm sells its product less the variable cost of producing the product. The contribution margin is calculated as

                 Revenue from the product- Product Variable Costs 
                              Revenue from the product                                     

Contribution margin" is also referred to as a per unit measure of a product's gross operating margin, calculated as the product's price minus its total variable costs. A larger contribution margin would make a company enjoy substantial profit increases during an economy’s upswing. It is also known as marginal income and is amount of money that is used to cover the fixed assets and generate profits.

Let us consider an example. If a business manager determines a particular product that has a 35% contribution margin, which is below that of other products in the company's product line. This figure would help the manager to determine whether variable costs for that product can be reduced, or if the price of the end product could be increased. In case these options are unattractive, then the manager may decide to drop the unprofitable product in order to produce an alternate product with a higher contribution margin.

Contribution margin analysis is good model to evaluate the performance of the department as a whole and its manager. But the contribution margin income statement is used internally by management because it is not acceptable for external reporting in the annual report. The contribution margin provides information on whether to add or remove products and product lines or to make informed pricing decisions.

The contribution margin arises in the cost-volume-profit analysis where it helps in the calculation of net income, and especially break even analysis. The contribution margin model is a measure of operating leverage which measures how growth in sales transforms into growth in profits.

Questions

• What is contribution margin? How is it calculated?
• What are the uses of contribution margin model?