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What is Contribution Margin and Why is it So Very Significant?

What is Contribution Margin
All you ever wanted to know about a contribution margin has been explained in this article. By calculating this valuable parameter, important decisions about the future of a product can be made.
BusinessZeal Staff
Last Updated: May 31, 2018
Contribution margin is an interesting and well-known concept in the field of accounting. It has special significance in the field of management accounting, which involves preparing and maintaining accounts for the use and reference of the top management of any company. Management accounting is strictly for internal purposes and has assumed great importance in these competitive times. Here's what you need to know about contribution margin.

Meaning

Contribution margin is generally described as the marginal profit earned for every unit sold by a company. It is used to judge how profitable every product launched by the company is and what can be the future earnings from these products. The formula to calculate it is very simple. To get this figure, you need to subtract the variable cost from the sales price. This has been stated in the form of a mathematical formula below.

Contribution margin = (Sales Price Received) - (Variable Cost Per Unit)

By knowing how profitable a particular product is, a company can decide whether to increase its production or decrease it as per need and financial position. The variable cost, which has been subtracted from the sales price received in the above formula consists of costs which increase with a change in levels of production and output by the company. Exactly opposite to this concept is the concept of fixed costs which will remain the same despite high or low production levels.

Once you know what contribution margin is and how to calculate it, you can always calculate the net operating profit or loss posted by the firm. For this calculation, you have an easy formula which has been stated below.

Net Operating Income or Loss = (Contribution Margin) - (Fixed Costs)

By substituting values in this equation, you can get the desired value easily. The net operating income can further be used for the calculation of the net profit which will be a figure not containing the expenses of the business. Contribution margin, like other concepts can also be expressed in terms of a percentage. To calculate its percentage, you may refer to the mathematical equation provided below.

Contribution Margin (%) = (Total revenue - Variable cost)/(Total Revenue) x 100

While discussing the contribution margin, we also need to know about fixed and variable costs in the businesses. As mentioned above, variable costs change with levels of production. Hence, raw material costs, sales commissions, and transport charges would be the variable ones. The fixed costs would remain constant, irrespective of the levels of production. Rent expenses, insurance expenses, salaries, and wages to workers or staff are some of the common fixed costs which all companies have to deal with.

The formulas provided above will help you calculate contribution margins easily and arrive at proper conclusions regarding the status of your business. Proper business development and financial management will ensure a smooth road to success.