The contribution margin helps to separate out the fixed cost and profit components coming from product sales and can be used to determine the selling price range of a product, the profit levels that can be expected from the sales, and structure sales commissions paid to sales team members, distributors or commission agents.
One-time costs for items such as machinery are a typical example of a fixed cost, that stays the same regardless of the number of units sold , although it becomes a smaller percentage of each unit's cost as the number of units sold increases. Other examples include services and utilities that may come at a fixed cost and do not have an impact on the number of units produced or sold. Another example of fixed cost is a website hosting provider that offers unlimited hosting space to its clients at a fixed cost.
Whether the client puts one or ten websites, and whether the client uses MB or 2 GB of hosting space, the hosting cost remains the same. In these kinds of scenarios, electricity and web-hosting cost s will not be considered in the contribution margin formula as it represents a fixed cost.
Fixed monthly rents or salaries paid to administrative staff also fall in the fixed cost category. However, if the same electricity cost increases in proportion to the consumption, and the web-host charges increase on the basis of the number of sites hosted and the space consumed, then the costs will be considered as variable costs.
Similarly, wages paid to employees who are getting paid based on the number of units they manufacture or any of its variations are variable costs. Each such item will be considered for contribution margin calculations. Fixed costs are often considered as sunk costs that once spent cannot be recovered. These cost components should not be considered while taking decisions about cost analysis or profitability measures.
These three components constitute the variable cost per unit. Such total variable cost increases in direct proportion to the number of units of the product getting manufactured. This cost of machine represents a fixed cost and not a variable cost as its charges do not increase based on the units produced. Such fixed costs are not considered in the contribution margin calculations.
However, contribution margin does not account for fixed cost components and considers only the variable cost components. The incremental profit earned for each unit sold as represented by contribution margin will be:. A key characteristic of the contribution margin is that it remains fixed on a per unit basis irrespective of the number of units manufactured or sold.
The profit per unit will come to:. However, the contribution margin, which gets calculated with respect to only the variable cost, will be:. The contribution margin remains the same, even when the number of units produced and sold has doubled. It provides another dimension to assess how much profits can be realized by scaling up sales. The contribution margin can help company management select from among several possible products that compete to use the same set of manufacturing resources.
Say that a company has a pen-manufacturing machine that is capable of producing both ink pens and ball-point pens, and management must make a choice to produce only one of them.
If the contribution margin for an ink pen is higher than that of a ball pen, the former will be given production preference owing to its higher profitability potential. Such decision-making is common to companies that manufacture a diversified portfolio of products, and management must allocate available resources in the most efficient manner to products with the highest profit potential.
Investors and analysts may also attempt to calculate the contribution margin figure for a company's blockbuster products. For instance, a beverage company may have 15 different products but the bulk of its profits may come from one specific beverage. Along with the company management, vigilant investors may keep a close eye on the contribution margin of a high-performing product relative to other products in order to assess the company's dependence on its star performer.
The company steering its focus away from investing or expanding the manufacturing of the star product, or the emergence of a competitor product, may indicate that the profitability of the company and eventually its share price may get impacted. But never look at contribution margin in a vacuum.
Before making any major business decision, you should look at other profit measures as well. Many leaders look at profit margin, which measures the total amount by which revenue from sales exceeds costs. Think about how company income statements usually work: You start with revenue, subtract cost of goods sold COGS to get gross profit , subtract operating expenses to get operating profit , and then subtract taxes, interest, and everything else to get net profit.
You might think of this as the portion of sales that helps to offset fixed costs. The first step in doing the calculation is to take a traditional income statement and recategorize all costs as fixed or variable. As a reminder, fixed costs are business costs that remain the same, no matter how many of your product or services you produce — for example, rent and administrative salaries.
Variable costs are those expenses that vary with the quantity of product you produce, such as direct materials or sales commissions. In fact, COGS includes both variable and fixed costs. Knight points to a client of his that manufactures automation equipment to make airbag machines. For this client, factory costs, utility costs, equipment in production, and labor are all included in COGS, and all are fixed costs, not variable.
Finance Books. Operations Books. Articles Topics Index Site Archive. About Contact Environmental Commitment. What is Contribution? How Contribution is Used The contribution concept is useful for determining the lowest possible price point at which products and services should be charged, and still cover all fixed costs. Thus, a detailed knowledge of contribution is useful in the following situations: Pricing.
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