Contribution margin is one of the most important concepts in managerial accounting. It is used extensively in planning and decision making because it is much easier to use than absorption costing, especially as variables change in the planning process.

Make more money now! Try our JOB search.

Contribution margin can be defined in a number of different ways. Contribution margin per unit is price less variable cost per unit. Total contribution margin is sales less total variable costs. These are the two definitions you will see most often for contribution margin. I like to define contribution margin as the amount from each unit that contributes to fixed cost and profit.

Let’s look back at the contribution margin income statement:

NoCMIS1tice that contribution margin less fixed cost is profit. In order to make a profit, total contribution margin must be greater than fixed costs. Once all of our fixed costs are paid for, any additional sales generate profit.

But how much profit? Each unit would generate profit equal to the contribution margin for that unit. If the contribution margin per unit is $10, then each additional unit sold would provide an additional $10 of profit.

Contribution margin is most often expressed as a monetary unit, but we can also express it as a percentage of price. This is called the contribution margin ratio. The contribution margin ratio tells us the percentage of each sales dollar that becomes contribution margin

Contribution margin ratio = contribution margin per unit / price

or

Contribution margin ratio = total contribution margin / sales

We can also look at variable cost as a ratio. The variable cost ratio tells us the percentage of each sales dollar that would go toward variable cost.

Variable cost ratio = variable cost per unit / price

or

Variable cost ratio = total variable cost / sales

As long as price and variable cost remain the same, these ratios will remain the same. It does not matter if the company sells 10 units or 1 million units, the percentage of each sale that becomes contribution margin or does to cover variable costs is the same.

Let’s look at an example to illustrate how to calculate contribution margin and these ratios.

Example #1

Hangout Limited, LLC sells one product priced at $40 per unit. The variable costs (direct materials, direct labor, variable overhead and variable selling) is $25 per unit. Calculate the contribution margin per unit, the contribution margin ratio and the variable cost ratio.

We know that contribution margin is price less variable cost. Therefore, contribution margin is:

$40 – $25 = $15

That means that for every unit we sell, $15 will go to cover fixed cost and profit. Once the fixed costs are paid, $15 per unit becomes profit.

Now calculate the ratios. We’ll start with the contribution margin ratio. Contribution margin ratio is contribution margin per unit divided by price per unit.

$15 / $40 = 37.5%

What does that mean? For every dollar of revenue the company brings in,  37.5% or 37.5 cents will become contribution margin. This also tells us that 37.5% of every sale is available to pay fixed costs or generate profit.

The variable cost ratio is variable cost per unit / price.

$25 / $40 = 62.5%

This tells us that for every unit sold, 62.5% will go to cover variable costs.

These ratios are important as we start to look at planning and decision making using contribution margin.

Related videos

Contribution Margin

Share This:


Related pages


effects of business transactions on the accounting equationformula for cost of good soldhow is depreciation expense calculatedpresent value interest factor of annuitycalculate my payroll taxeswhen are debits increases and decreasesis common stock a current assetaccounts receivable reconciliation examplecogs percentagefica wage basedouble decline balance depreciationfixed cost vs variable cost exampleswip productionan example of an accrued revenue isadjusting journal entries examplejob order costing system examplejournal entry unearned revenuepresent value of ordinary annuity calculatorhow to prepare income statement from trial balanceaccounting equation and its componentswhat is considered stockholders equitylabor cost calculatorequity accounting entriescalculate total fixed cost formulatrading securities journal entriesjournal entry for advance salary paidsalary received journal entrycollected accounts receivable journal entryfifo perpetual inventory systempurchase accounting journal entrieshow to calculate closing stock without gross profitjournal entry for collection of accounts receivablepresent value of an ordinary annuity of 1 tablefed withholding ratejournal entry for warrantyjanitor payoverhead rate calculatorcalculate cogsincome statement cogsgaap bad debtcalculating taxes from paycheckpremium bond valuepresent value annuity factor tablefifo inventory calculatorstock option accounting journal entriesstatement of retained earnings equationinventory fifo methodwhy do companies make adjusting entriesexamples of merchandisingwhy is unearned revenue a liabilitycalculating ficaunearned revenue areequipment depreciation calculatorvariable manufacturing overhead formulaordinary annuity payment calculatorapplied overhead rate formulabond valuation sample problemsis merchandise inventory an assetprepayment journal entryclosing income summarymaterial costing in cost accountingformula to calculate fixed costvariable cost per unit calculationaccounting entry for provision for doubtful debtscash sales journalnet pay calculation formulavariable expenses ratiotop side adjusting journal entryordinary annuity vs annuity dueperiodic and perpetualcost of applesauce