Contribution margin is a key metric used in cost-volume-profit analysis. It is defined as the amount of sales revenue that remains after subtracting the variable costs associated with producing those goods or services. The contribution margin can be expressed as either a dollar amount (total contribution margin) or as a percentage of sales.
The formula for calculating contribution margin is:
Contribution Margin = Revenue – Variable Costs
Variable costs are costs that vary with the number of units produced and sold, such as material and labor costs. Fixed costs, such as administrative salaries and rent, are not included in this calculation.
By calculating contribution margin on individual products and services, businesses can determine which products are most profitable and make decisions about pricing, production levels, marketing strategies, product mix and other key business decisions. It also helps to identify areas where businesses may want to increase efficiency by reducing variable costs. For example, if one product has a higher contribution margin than another but similar variable costs then it might be worth investing in ways to reduce those variable costs for both items so that profits can be increased across the board.
