what contribution margin can tell you
the contribution margin is the foundation for break even analysis used in the overall cost and sales price planning for products the contribution margin helps to separate out the fixed cost and profit components coming from product sales and can be used to determine the selling price range of a product the profit levels that can be expected from the sales and structure sales commissions paid to sales team members distributors or commission agents fixed cost vs variable costfixed cost are costs that are incurred independent of how much is sold or produced the business pays them to establish itself and exist buying items such as machinery are a typical example of a fixed cost specifically a one time fixed cost regardless of how much it is used and how many units are sold its costs remains the same however these fixed costs become a smaller percentage of each unit s cost as the number of units sold increases another common example of a fixed cost is the rent paid for a business space a store owner will pay a fixed monthly cost for the store space regardless of how much goods are sold on the other hand variable costs are costs they depend on the amount of goods and services a business produces for example a factory needs raw materials to produce products the more it produces in a given month the more raw materials it requires those raw materials are therefore a variable cost likewise a cafe owner needs things like coffee and pastries to sell to visitors the more customers she serves the more food and beverages she must buy their cost is variable these costs would be included when calculating the contribution margin fixed costs are often considered sunk costs that once spent cannot be recovered these cost components should not be considered while taking decisions about cost analysis or profitability measures contribution margin vs gross profit marginthe contribution margin is different from the gross profit margin the difference between sales revenue and the cost of goods sold while contribution margins only count the variable costs the gross profit margin includes all of the costs that a company incurs in order to make sales the contribution margin shows how much additional revenue is generated by making each additional unit product after the company has reached the breakeven point in other words it measures how much money each additional sale contributes to the company s total profits example of contribution marginsay a machine for manufacturing ink pens comes at a cost of 10 000 manufacturing one ink pen requires 0 2 worth of raw materials like plastic ink and nib another 0 1 goes towards the electricity charges for running the machine to produce one ink pen and 0 3 is the labor charge to manufacture one ink pen these three components constitute the variable cost per unit the total variable cost of manufacturing an ink pen comes to 0 2 0 1 0 3 0 6 per unit if a total of 100 ink pens are manufactured the total variable cost will come to 0 6 100 units 60 while manufacturing 10 000 ink pens will lead to a total variable cost of 0 6 10 000 units 6 000 such total variable cost increases in direct proportion to the number of units of the product getting manufactured however ink pen production will be impossible without the manufacturing machine which comes at a fixed cost of 10 000 this cost of the machine represents a fixed cost and not a variable cost as its charges do not increase based on the units produced such fixed costs are not considered in the contribution margin calculations if a total of 10 000 ink pens are manufactured using the machine at a variable cost of 6 000 and at a fixed cost of 10 000 the total manufacturing cost comes to 16 000 the per unit cost will then be computed as 16 000 10 000 1 6 per unit if each ink pen is sold at a price of 2 per unit the profit per unit comes to sp tc 2 0 1 6 0 4 per unit where sp sales price tc total costs begin aligned text sp text tc 2 0 1 6 0 4 text per unit textbf where text sp text sales price text tc text total costs end aligned sp tc 2 0 1 6 0 4 per unitwhere sp sales pricetc total costs however the contribution margin does not account for fixed cost components and considers only the variable cost components the incremental profit earned for each unit sold as represented by contribution margin will be sp tvc 2 0 0 6 1 4 per unit where sp sales price tvc total variable costs begin aligned text sp text tvc 2 0 0 6 1 4 text per unit textbf where text sp text sales price text tvc text total variable costs end aligned sp tvc 2 0 0 6 1 4 per unitwhere sp sales pricetvc total variable costs a key characteristic of the contribution margin is that it remains fixed on a per unit basis irrespective of the number of units manufactured or sold on the other hand the net profit per unit may increase decrease non linearly with the number of units sold as it includes the fixed costs uses of contribution marginthe contribution margin can help company management select from among several possible products that compete to use the same set of manufacturing resources say that a company has a pen manufacturing machine that is capable of producing both ink pens and ball point pens and management must make a choice to produce only one of them if the contribution margin for an ink pen is higher than that of a ball pen the former will be given production preference owing to its higher profitability potential such decision making is common to companies that manufacture a diversified portfolio of products and management must allocate available resources in the most efficient manner to products with the highest profit potential investors and analysts may also attempt to calculate the contribution margin figure for a company s blockbuster products for instance a beverage company may have 15 different products but the bulk of its profits may come from one specific beverage along with the company management vigilant investors may keep a close eye on the contribution margin of a high performing product relative to other products in order to assess the company s dependence on its star performer the company steering its focus away from investing or expanding the manufacturing of the star product or the emergence of a competitor product may indicate that the profitability of the company and eventually its share price may get impacted 