What is a Contribution Margin?
Ahead of discussing how to calculate contribution margin, lets begin by defining it. In accounting, contribution margin is the amount by which your business’s sales revenue exceeds your variable costs. It’s just another way of looking at profit.
Generally speaking, you want your contribution margin to be as high as possible. A high contribution margin means that you make more from your products than they cost to produce and are in a strong position to cover your fixed costs. A low contribution margin simply means that your margins are slim and that you’ll need to sell a high volume to make a decent profit and pay your fixed costs.
There are two ways for a company to increase its contribution margins;
- They can find ways to increase revenues.
- They can reduce their variable costs.
Importance of Contribution Margin.
- When a company is deciding on the price of selling a product, contribution margin is frequently used as a reference for analysis.
- A contribution margin is important because it shows how much money is available to pay the fixed costs such as rent and utilities.
- A low or negative contribution margin indicates a product line or business may not be that profitable, so it is not wise to continue making the product.
- It is important to assess the contribution margin for breakeven or target income analysis.
- To resolve bottlenecks, contribution margin can be used to decide which products offered by the business are more profitable and, therefore, more advantageous to produce.
Formula to Calculate Contribution Margin.
Suppose a company’s total sales were $ 350,000 while the total variable costs was $ 80,000. Calculate the contribution margin.
Thus, the company’s contribution margin is $ 270,000.