The contribution margin method is a way by which companies can determine their profitability for products they sell or services they provide. The contribution margin also helps them determine how many units of a particular product they must sell to break even. The break-even point occurs when a product's revenue equals its costs.
The purpose of calculating the contribution margin is for companies to determine how much revenue from sales is available for use toward fixed costs. Knowing the contribution margin and contribution margin ratio helps merchants to determine their operating leverage. Operating leverage is an analysis of fixed and variable costs measuring how an increase in sales revenue affects a company's gross profits.
Contribution Margin Equation
In contribution margin calculations, analysts consider variable and not fixed costs. The equation to determine the contribution margin is sales revenue minus variable costs. Analysts may also determine the contribution margin per individual unit by subtracting the variable cost per unit from the sales revenue per unit. Calculating the per unit contribution margin allows analysts to see which items are most profitable compared to their costs and which ones are least profitable.
Contribution Margin Ratio
The contribution margin ratio allows analysts to see how each one dollar increase in sales effects the contribution margin. When the contribution margin changes, net income also changes. High contribution margins mean a larger portion of revenue from sales is going toward profits. A low contribution margin ratio means a smaller portion of revenue from sales is going toward profits and a larger portion is going toward paying fixed costs. The equation for the contribution margin ratio is the contribution margin divided by sales.
Knowing the contribution margin and contribution margin ratio allows companies to adjust their variable costs in an attempt to make a product more profitable. It also allows a company to make product or service line decisions. For instance, a company that has a product with a low contribution margin ratio may consider reducing production quantities to lower variable costs. The company could then recalculate the product's contribution margin after a time. If reducing the variable costs does not result in making it more profitable, the company may decide to discontinue production of the item.
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