Contribution Margin Meaning
When an individual is burning 8000 calories per day and his or her intake of calories is 10000 calories than this extra 2000 calorie gets deposited as fat in the human body, in the case of companies similar process happens where the excess of sales over variable cost is deposited for fixed cost and it is called contribution margin. Contribution margin is the term used in the context of accountancy; it is very useful concept when it comes to finding out whether the company is able to meet its variable expenses from the revenue generated from sales done by the company.
Contribution Margin Formula
The formula for calculating contribution margin is Sales less Variable Costs. It helps the company in knowing whether the company has been making more variable expenses or less variable expense because a higher margin implies that company has been incurring lower variable cost which is the case in capital intensive industries and a lower margin implies that company has been incurring higher variable cost which is the case with labor-intensive industries.
Contribution Margin Example
This concept can be better understood with the help of an example, suppose a company sells 10000 units at $20 and variable cost per unit is $5 than company’s contribution margin will be $150000 while contribution margin per unit which is calculated as selling price – variable cost divided by selling price per unit is 75% which is calculated as $20-$5/$20. Higher the contribution margin the better it is because the company has more amount for fixed costs, however, it is not necessary that company having higher margin will also have higher profits as in some industries fixed costs component is higher and in those industries higher margin does not guarantee high profits.
As one can see from the above that contribution margin is very important concept when it comes to analyzing the variable cost impact on the profits of the company as well as while doing break-even point analysis which is a situation of no profit no loss as far as the company is concerned.