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:

Notice 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

## Related pages

declining balance method of depreciation formulapreparing adjusted trial balancesample income statementsmarket value of bond formulaaccounts receivable credit or debit balanceis prepaid expense an asset2014 fica wage basewhat is the difference between adjusting entries and correcting entriesmarketing and selling expensesgaap accounts receivablecalculate pv factorprovision for uncollectible accountssales returns and allowances definitionpurchase price allocation examplejournalize closing entriespayroll accrual journal entryincome statement cost of goods manufacturedan example of a contra asset account istotal contributed capital formulaadjusting trial balance examplesfifo accountingjournal entry accounts payabledepreciation on factory equipmentbasics of journal entriesfixed assets depreciation methodsprocess costing weighted average methodfixed cost per unit increases whenweighted total calculatorpresent worth factor tableaccumulated depreciation calculation examplemanufacturing overhead allocated formulacosting accounting formulaspayroll tax rate calculatoris accumulated depreciation a liabilityunearned interest income journal entrytypes of fixed expensespresent value of annuitywhat is difference between trial balance and balance sheetjob costing example problemrumus variable costhow much is ss and medicare taxbook reconciling itemsjournal entries for bank reconciliation exampletrial balance entries examplesestimating allowance for doubtful accountsfederal witholding tax rateaccounting contra accountsunder the allowance method writing off an uncollectible accountbeginning inventory plus the cost of goods purchased equalszero coupon bond journal entryrecognizing accounts receivableaccounting trial balance worksheetexamples of liabilities accountsselling and administrative costunits of output depreciationmanagerial accounting income statementbond discount amortization schedulebad debts written off balance sheetan adjusting entry affectsformula for contribution margin per unitabsorption costing approachwhy is a trial balance prepareddepreciable cost formulapresent value lump sumgross up wages calculatorfinancial accounting journal entry exampleswhat are outstanding chequesformula for reducing balance depreciationwhich of the following accounts is a stockholders equity accountreversing entries examplessimple interest monthly payment formulaperpetual discountsample statement of retained earningshow do you calculate contribution margin per unitcost of finished goods available for sale formula