Contribution Margin

Contribution Margin (Usually represented as Contribution Margin Ratio) is a measure used to evaluate the feasibility and profitability of individual products or services. It is also used when calculating the Break Even Point₁.

A healthy business considers Fixed and Variable costs when setting the prices for its products and services offered in order to ultimately become profitable. The Contribution Margin calculates the margin by which a given product or service can return a value exceeding the cost used to produce it, therefore covering other fixed costs of the business or generating profit.

To calculate the Contribution Margin, we need 2 variables:

1. Price of the product/service being sold
2. Total variable costs associated in producing this particular product/service

Under the same concept, the Contribution Margin Ratio is the percentage by which the contribution margin does bring back relative to the sales of the products/services.

Contribution Margin: Variable vs. Fixed costs

As you you may have noted from the equations above, the contribution margin needs the "Variable Costs" to be identified. Why is that and what about "Fixed Costs"?
 
Looking at the contribution margin itself, it is often considered on per-a-product or per-a-service rate. Meaning that different products and services have different contribution margins. this is because the contribution margin ratio helps us differentiate different products to see what best contributes to the baseline, thus putting it first in our offering. This goes seamlessly with the variable cost (that is associated with the production of each good or service), so we consider the variable costs in the contribution margin equation. As for the fixed costs (associated with the business itself), it is considered an overall cost for the business- in other words, it would be the same for different products and services.

Effect of Contribution Margin on Product Offerings

Following the Contribution Margin value we can determine product offerings easier. In general, products with more margin mean that they contribute more to the base line and thus should be highlighted in the offer. Products of lower contribution margin should be move back in the offer.
 
The example image here shows an example on this. A shoemaker has three main products different in their texture and raw materials used, and different with their prices, thus the different contribution margin. Here, the shoe with the highest contribution margin moves to be the #1 offer and is featured by the shoemaker.

Contribution Margin Example 1:

For example, let’s say Golden Frames is a company that produces wooden frames for photos, and has the following variables:

• Its overall fixed costs are $30,000
• Its variable cost per frame is $2
• Its price per frame is $5

Contribution Margin would be:

The result of the above will be 60% - meaning that every frame brings back $3 to contribute towards fixed expenses of $30,000.
In other words: every frame sold contributes 60% of its value towards fixed expenses of $30,000. We can easily use this information to calculate the break-even point. Once the fixed expenses are paid, the same $3 will be the profit for each frame sold.

Contribution Margin Example 2:

Fresh Bakery produces pies that have the following monthly costs

From the above table, Fresh Bakery must have a price of at least 0.5 for every pie to cover the variable expenses.
If we suggest the price per pie is $2, this means we have $1.5 contribution margin ($2 for the pie- 0.5 for variable costs for each pie).

So the Contribution Margin Ratio for Fresh Bakery is 75%