Contribution Margin
Contribution Margin is the difference of the amount that is left from the sales after covering the associated variable costs. After deducting the variable costs (which are directly related to the production of goods or services) the contribution margin is obtained which is used to cover the fixed costs.Contribution margin is literally the amount that a department is forwarding or contributing to the fixed costs. In any given company (manufacturing or service), contribution margin is important to understand how different departments cover their relevant (variable) costs and how much money is left to cover the fixed costs such as administration, rent, insurance, etc.
Contribution Margin Formula
It is important to understand the relevant formulas associated with contribution margin.Operating income = Revenue − variable costs − Fixed costs
Contribution margin = Sales − variable cost
Contribution margin ratio = (Sales − Variable costs) / Sales
Unit Contribution margin ratio = (Contribution margin per unit − unit sales price) / Unit Sales
Providing an example/scenario can help understand more about contribution margin
Example of Contribution Margin Problem - Scenario
Penkorisa Inc. specializes in the production of three products namely; plain paper, notebooks, and folders. Penkorisa Inc. incurred fixed costs of $100,000 during the year. Based on the data given below for Penkorisa's year end, what was the contribution margin for each of the departments?
| Department | Sales | Variable costs |
|---|---|---|
| Plain Paper | $240,000 | $40,000 |
| Notebooks | $350,000 | $100,000 |
| Folders | $250,000 | $80,000 |
Solution Using Contribution Margin Approach
The following are the formulas to use in computing the contribution margin for each of the departments:Contribution margin = Sales − variable cost
Contribution margin ratio = (Sales − Variable costs) / Sales
| Department | Contribution margin | Contribution margin ratio |
|---|---|---|
| Plain Paper | $200,000 | 83.3% |
| Notebooks | $250,000 | 71.4% |
| Folders | $170,000 | 68% |
Explanation
From the calculations above, the plain paper department has the highest contribution margin ratio than the other departments.