Contribution margin, or dollar contribution per unit, is the selling price per unit minus
the variable cost per unit.
“Contribution” represents the portion of sales revenue that is not consumed by variable
costs and so contributes to the coverage of fixed costs.
This concept is one of the key building blocks of break-even analysis.
In cost-volume-profit analysis, a form of management accounting, contribution margin—the
marginal profit per unit sale—is a useful quantity in carrying out various calculations,
and can be used as a measure of operating leverage.
Typically, low contribution margins are prevalent in the labor-intensive tertiary sector while
high contribution margins are prevalent in the capital-intensive industrial sector.
Purpose Contribution arises in Cost-Volume-Profit
Analysis, where it simplifies calculation of net income and, especially, break-even
analysis.
Given the contribution margin, a manager can easily compute breakeven and target income
sales, and make better decisions about whether to add or subtract a product line, about how
to price a product or service, and about how to structure sales commissions or bonuses.
Contribution margin analysis is a measure of operating leverage; it measures how growth
in sales translates to growth in profits.
The contribution margin is computed by using a contribution income statement, a management
accounting version of the income statement that has been reformatted to group together
a business's fixed and variable costs.
Contribution is different from gross margin in that a contribution calculation seeks to
separate out variable costs from fixed costs on the basis of economic analysis of the nature
of the expense, whereas gross margin is determined using accounting standards.
Calculating the contribution margin is an excellent tool for managers to help determine
whether to keep or drop certain aspects of the business.
For example, a production line with positive contribution margin should be kept even it
causes negative total profit, when the contribution margin offsets part of the fixed cost.
However, it should be dropped if contribution margin is negative because the company would
suffer from every unit it produces.
The contribution margin analysis is also applicable when the tax authority performs tax investigations,
by identifying target interviewees who have unusually high contribution margin ratios
compared to other companies in the same industry.
Contribution margin is also one of the factors to judge whether a company has monopoly power
in competition law, such as use of the Lerner Index test.
Construction The Unit Contribution Margin is Unit Revenue
minus Unit Variable Cost:
The Contribution Margin Ratio is the percentage of Contribution over Total Revenue, which
can be calculated from the unit contribution over unit price or total contribution over
Total Revenue:
For example, if the price is $10 and the unit variable cost is $2, then the unit contribution
margin is $8, and the contribution margin ratio is $8/$10 = 80%.
Contribution margin can be thought of as the fraction of sales that contributes to the
offset of fixed costs.
Alternatively, unit contribution margin is the amount each unit sale adds to profit:
it is the slope of the profit line.
Cost-Volume-Profit Analysis: assuming the linear CVP model, the computation of Profit
and Loss reduces as follows:
where TC = TFC + TVC is Total Cost = Total Fixed Cost + Total Variable Cost and X is
Number of Units.
Thus Profit is Unit Contribution times Number of Units, minus the Total Fixed Costs.
The above formula is derived as follows: From the perspective of the matching principle,
one breaks down the revenue from a given sale into a part to cover the Unit Variable Cost,
and a part to offset against the Total Fixed Costs.
Breaking down Total Costs as:
one breaks down Total Revenue as:
Thus the Total Variable Costs offset, and the Net Income is Total Contribution Margin
minus Total Fixed Costs:
Examples The Beta Company's contribution margin for
the year was 34 percent.
This means that, for every dollar of sales, after the costs that were directly related
to the sales were subtracted, 34 cents remained to contribute toward paying for the indirect
costs and later for profit.
Contribution format income statements can be drawn up with data from more than one year's
income statements, when a person is interested in tracking contribution margins over time.
Perhaps even more usefully, they can be drawn up for each product line or service.
Here's an example, showing a breakdown of Beta's three main product lines.
Although this shows only the top half of the contribution format income statement, it's
immediately apparent that Product Line C is Beta's most profitable one, even though Beta
gets more sales revenue from Line B. It appears that Beta would do well by emphasizing Line
C in its product mix.
Moreover, the statement indicates that perhaps prices for line A and line B products are
too low.
This is information that can't be gleaned from the regular income statements that an
accountant routinely draws up each period.
Contribution margin as a measure of efficiency in the operating room
The following discussion focuses on Contribution Margin per operating room hour in the operating
room and how it relates to operating room efficiency.
FIGURE: Metric Measure for OR Efficiency A surgical suite can schedule itself efficiently
but fail to have a positive contribution margin if many surgeons are slow, use too many instruments
or expensive implants, etc.
These are all measured by the contribution margin per OR hr.
The contribution margin per hour of OR time is the hospital revenue generated by a surgical
case, less all the hospitalization variable labor and supply costs.
Variable costs, such as implants, vary directly with the volume of cases performed.
This is because fee-for-service hospitals have a positive contribution margin for almost
all elective cases mostly due to a large percentage of OR costs being fixed.
For USA hospitals not on a fixed annual budget, contribution margin per OR hour averages one
to two thousand USD per OR hour.
See also Break-even
Cost-Volume-Profit Analysis Gross margin
References
Other sources Cost-Volume-Profit Analysis; Chapter 11 at
MAAW Cost-Volume-Profit Analysis at CliffNotes
Cost-Volume-Profit Analysis at Answers.com
External links MASB Official Website