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.
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
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
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.
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.
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