Contribution margin is the actual profit earned from each unit of product or services sold. In other words, contributions margin is what is left when we subtract from the price of a product all the associated variable cost. Also known as dollar contribution per unit, it measures how a specific product contributes to the overall profit if the company. It also shows the portion of the sales that help to cover the company fixed costs.
The contribution margin is calculated as the difference between the sales price of the product and the variable costs associated with the production and sales of the product.
Contribution margin = Sales revenue - Variable costs
To calculate the contribution margin as percentage we can just divide the above formula over the sales revenue.
For example, if the sale price of your product is $200 and the unit variable cost is $40, then the unit contribution margin is $260.
Another way to look at is in the frame of break even analysis. For example if a company does the calculation and figures out the for a specific product its contribution margin is $5 per product sold. If the fixed cost of the company for that period is $50000, then the break even number would be to sell 10 000 units for the same period of time.
The contribution is the basis of making a break-even assessment of a product and can help us determinate the minimum price that the product can be sold for or how to structure sales commissions. The most common use of contribution margin metric is to compare different products and determine which to keep and which to discontinue. It helps us to make a difference between fixed costs and variable costs in the process of making and selling a product and services. Fixed costs stay the same no matter the number of units sold and therefore become smaller and smaller fraction of the cost as the number of units sold grows. Variable costs on the other hand grow proportionally with the number of units sold and as such should be be considered for contribution margin calculations. If a product’s contribution margin is negative, the company is losing money with each unit it produces.