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Contribution Margin is an accounting term used to identify the amount of funds available to pay for corporate fixed costs. To explain contribution margin and its importance, let’s go back a few steps.
Firstly, you will need to understand three terms to fully appreciation contribution margin. The three contribution margin terms are Selling Price, Variable Costs and Fixed Costs. Each item is discussed below.
The selling price is quite straight forward. Assuming we are discussing the contribution margin on a per unit basis, the selling price would be the amount you sell your product for. Let’s assume your selling price is $50.00 per unit.
The next item important for contribution margin is variable cost per unit. Many find it difficult to grasp the meaning behind a variable cost. Here’s a simple definition which will enable you to easily understand its meaning.
A variable cost, as it relates to contribution margin, is a cost or expense that fluctuates with the sale of one additional unit or product. Meaning, if you sold one product for $50 and it cost you $30 to purchase, then the variable cost per unit is $30. In other words, if you sold the same type of product again, it will cost you another $30.00. The $30.00 is considered a variable cost per unit because this cost will fluctuate or increase if you sell an additional unit of product.
Now we have enough information for contribution margin. The variable cost is subtracted from the selling price to arrive at Contribution Margin. In our case, the contribution margin is $20.00 per unit. $50.00 selling price per unit less $30.00 variable cost per unit = $20.00 per unit.
At the beginning of this article, we mentioned three terms are important for contribution margin. We already discussed the selling and variable cost. The third and final term is known as a Fixed Cost. Below discusses its importance as it relates to contribution margin.
Fixed costs are costs and expenses which do NOT fluctuate with the sale of one additional product. These costs are completely the opposite of variable costs as it relates to contribution margin. When determining whether an expense is a fixed cost, simply ask yourself this question. If I sold one more additional product, will I incur more of this specific cost or expense? Let’s explain by using a popular expense such as office supplies. Let’s go further and say the office supply is a calculator.
So here’s the simple question which will differentiate a fixed cost from a variable cost which is required for contribution margin. If I sell one more unit of product, will I need to purchase more calculators? Unless the product you’re selling are calculators, the answer will always be no. Therefore, the cost of the calculator is considered a fixed cost. In other words, this office supply expense does not fluctuate when an additional sale is made.
You can use this exercise with every business cost and expense to determine whether the item is a fixed cost or a variable cost.
You might be asking yourself, why we are discussing fixed costs when we already know how to find contribution margin. By doing so, it will enables you to fully understand the meaning behind the term contribution margin. Here’s how.
Ok, let’s assume a company anticipates its upcoming fixed costs for the year at $100,000. Also, let’s continue to use the $20.00 contribution margin from above. So here’s the importance and the meaning behind the term contribution margin. For every sale made by the company, $20.00 is “contributing” (paying) towards the fixed costs. Once all the fixed costs are paid, every sale thereafter will be considered profit.
Also, knowing the contribution margin and total fixed costs for the upcoming year are important components to a popular accounting term known as breakeven point. The break even point formula divides the contribution margin into the total fixed costs. Assuming fixed costs for the upcoming year are expected to be $100,000 and the contribution margin (from above) is $20.00, the break even point is 5,000 units. This means, after 5,000 units are sold, each unit sale thereafter contributes to profit (i.e. is complete Profit). For additional information on this topic, please refer to the section break-even analysis.
From the above discussion, it’s clear to see why business owners would be interested in contribution margin. Contribution Margin can be applied to many situations to answer a number of key business questions. Once you find your contribution margin, you’ll discover it will remain relatively stable from year to year.
For additional information, please refer to the contribution margin ratio.
The above discussion dealt with a contribution margin for a single product. If you sell multiply products, you will need to determine a weighted average contribution margin. Weighted Average Selling Price and Weighted Average Cost will provide you with all the information needed to find this type of contribution margin.