"Contribution margin" means the sales revenue that remains after variable costs (like the cost of goods, sales commissions and delivery charges) have been deducted.
Contribution margin analysis can be an extremely useful decision-making tool. By revealing how profitable an individual product or service really is, it helps managers channel their resources effectively, and make informed decisions about issues like: investment and pricing; which lines to develop and which to drop; where to direct expertise; competing in the marketplace; commission and bonus rates; and where to focus marketing and advertising budgets.
The formula is simply the price of the product minus variable costs:
Or for a service, the total revenue:
Suppose a product sells at $800 and variable cost is $525, the contribution margin is $275, or 34.38% of the selling price. So for every dollar of revenue, 34.38 cents remain to cover fixed costs and contribute to overall profit.
A business with several product lines or services can use contribution margin analysis to compare their profitability:
|Product × ($)||Product Y ($)||Product Z ($)|
|Contribution margin (%)||32||44.55||43.75|
From this quick analysis, a manager can see that even though product × generates the highest sales income, its contribution margin is lower than for products Y and Z. Perhaps × is selling too cheaply, or something can be done to bring down the variable costs to a level proportionate with Y & Z. The manager might also want to think about increasing sales of the most profitable lines.
A clearer, longer-term picture can be gained by extrapolating figures from several consecutive years of income tax returns (note that the information does not appear in this exact form). The data is also important for identifying break-even sales or volume levels, and in working out deals for favored customers.
- For contribution margin analysis to be meaningful, all variable costs must be accounted for, including direct costs like labor and materials, and the indirect costs of services. Activity-based cost accounting systems are helpful in this context.
- Contribution margin analysis is not a particularly sophisticated tool. For instance, it does not allow for marketing strategies like loss leaders, or consider issues like market penetration, opportunities, or threats to established markets by upcoming competitors.
Business Owner's Toolkit: www.toolkit.cch.com