Contribution margin indicates how much profit you are earning on the goods or services you sell, without accounting for your company’s fixed costs or operating costs. To calculate it, subtract variable costs from sales.
A company might have a product line with a positive contribution margin even if its impact to net profit is negative. The contribution margin it generates helps pay for fixed costs. If its contribution margin is negative, however, the company loses money with each unit it produces. Since it can’t make up that kind of loss with volume, it should either drop the product line or increase prices.
In our example below, revenue is $10,000 and the variable costs are $4,500, the calculation is as follows:
(Excerpts from Financial Intelligence, Chapter 9 – The Many Forms of Profit)
Contribution margin is sales minus variable costs. It shows the profit you are earning on what you sell before you account for fixed costs.
Contribution margin shows you the aggregate amount of margin available after variable costs to cover fixed expenses and provide profit to the company. In effect, it shows you how much you must produce to cover your fixed costs.
Contribution margin analysis helps managers compare products, make decisions about whether to add or subtract a product line, decide how to price a product or service, and even how to structure sales commissions.