1. Definition
Contribution margin is equal to sales revenue less total variable expenses incurred to earn that revenue. Total variable expenses include both manufacturing and non-manufacturing variable expenses. In a service firm, contribution margin is equal to revenue from provision less all variable expenses incurred to provide such services.
Contribution margin is the amount by which an item contributes towards covering fixed costs and profitability of the business. It is therefore a very important input for many CVP decisions and is usually computed for a single product, multiple product together, a particular profit center and the business as a whole depending on the need of the management.
Contribution margin = Sales revenue - Variable expenses
The equation or formula of contribution margin can be written. The concept can best be explained with the help of an example.
2. Example A
| Number of units produced and sold | 1000 |
|---|---|
| Sales price per unit | 10 |
| Per unit variable manufacturing expenses | 4 |
| Per unit variable marketing and administrative expenses | 1 |
| Net income | 1750 |
| Total fixed manufacturing expenses | 2000 |
| Total fixed marketing and administrative | 500 |
Contribution margin = Sales revenue - Variable expenses
= 1000*10 - 1000*4 - 1000*1
= 5000
And the net operating income is,
Net operating income = Contribution margin - Fixed expenses
= 5000 - 2000 - 500
= 2500
The use of equation to calculate contribution margin figure is just for explaining the concept. For managerial use, a proper contribution margin income statement is prepared to compute this figure. The amount of contribution should be sufficient to cover all fixed costs as well as contribution towards profit. If the amount of contribution margin is not enough to cover all fixed costs, the business will suffer a loss.
Contribution margin figure is even more important for multi product companies. Normally, all products sold by a company are not equally profitable. High contribution margin products are more proftbale because they contribute more for covering fixed costs and providing for profit. A multi product company can increase its net operating profit by focusing its attention to increase the sales of high contribution margin products or finding the ways to reduce variable cost of low contribution margin products.