Contribution Margin

Contribution margin (CM) is the amount by which sales revenue exceeds variable costs. It is the net amount that sales ‘contribute’ towards periodic fixed costs and profits. It is expressed either as total contribution margin, contribution margin per unit or contribution margin ratio.

Variable costs are costs which vary directly with sales. For example, if sales double, variable costs double too, and vice versa. Variable cost may be direct as well as indirect. Direct variable costs include direct material cost and direct labor cost. Indirect variable costs include certain variable overheads.

Total contribution margin is calculated by subtracting total variable costs from total sales. Contribution margin per unit equals sales price per unit minus variable costs per unit or it can be calculated by dividing total contribution margin by total units sold. Contribution margin ratio equals contribution margin expressed as a percentage of sales. Weighted average contribution margin per unit equals the sum of contribution margins of all products divided by total units. Weighted average contribution margin ratio equals the sum of contribution margins of all products divided by total sales.

Contribution margin is an important input in calculation of breakeven point, i.e. the sales level (in units and/or dollars) at which a company makes zero profit. Breakeven point (in units) equals total fixed costs divided by contribution margin per unit and breakeven point (in dollars) equals total fixed costs divided by contribution margin ratio.

Contribution Margin vs Gross Margin

Contribution margin is the intermediate profit that appears on variable costing income statement, while gross profit margin, which equal sales minus all product costs (direct materials, direct labor and manufacturing overheads), appears on absorption costing income statement. In contribution margin income statement, all costs are classified between variable and fixed, while in gross profit (absorption costing) income statement, costs are classified into products costs and period costs.

Example

Jump, Inc. is a sports footwear startup which currently sells just one shoe brand, A. The sales price is $80, variable costs per unit is $50 and fixed costs are $2,400,000 per annum. During financial year 2015, the company sold 200,000 units. Calculate the company’s contribution margin for the period and calculate its breakeven point in both units and dollars.

Solution

Contribution margin per unit
= sales price – variable cost per unit
= $80 – $50 = $30

Total contribution margin
= total sales – total variable costs
= units sold * sales price – units sold * variable cost per unit)
= units sold * (sales price – variable cost per unit)
= $80 * 200,000 - $50 * 200,000
= 200,000 ($80 - $50)
= $6,000,000

Total contribution margin can also be calculated as follows:

Total contribution margi
= contribution margin per unit * unit sales
= $30 * 200,000 = $6,000,000

Breakeven point in units
= fixed costs/contribution margin per unit
= $2,400,000/$30 = 80,000 units

Breakeven point in dollars
= breakeven point in units * sales price
= 80,000 * $80 = $6,400,000

Written by Irfanullah Jan