Contribution margin Definition:

Contribution margin is a tool used in cost accounting to determine each product category or units break even in terms of its revenue contribution and variable cost involved to make a sale. The difference between Sales revenue and variable cost is a referred as contribution margin from a product or service company offers. This enables product managers and marketers to fix the selling price and offers discounts and place promotions to cover direct or variable costs and keep handsome margin to cover other fixed expenses to make product or service as a variable in sales funnel.

Contribution Margin Analysis:

While analysing the contribution margin one needs to consider the structure of each product sales process and its design to attached various important components of variable costs involved. This may vary even for a same product based on order quantity and other costs involved in transportation.

Contribution Margin example:

Company XYZ sells a product for $500 and incurs a variable cost of $100 for raw material, $10 for packaging, $50 for Transportation and $100 for labour and $50 as variable overhead. And $100 as fixed cost. (Fixed Cost is not considered while calculating Contribution Marin)

Scenario One: The Company XYZ sells around 1000 units of the products this year with all variable costs mentioned above.

Contribution margin is = (500*1000) -(100*1000+10*1000+50*1000+100*1000+50*1000) = $190k or $190 per unit. Contribution Margin Ratio is 38%

Scenario Two: Company XYZ gets a bulk order for 5000 Units and the price negotiated is $400 per unit, assuming Raw Material and Labour cost remain the same, but Transportation and Package Expenses go down to $25 and $5 respectively.

Contribution Margin is = (400*5000) – (100*5000+5*5000+25*5000+100*5000+50*5000) = $600k or $120 per unit. Contribution Margin Ratio is 30%.

Now, Although the contribution margin Ratio is Scenario Two for the company xyz is less than in the case of Scenario one the Net Profit Ratio is what may stand attractive, let’s look at this:

Net Margin in Scenario One:

Where net margin is = 18%

Net Margin Scenario Two:

Where net margin is = 25%

Economies of Scale may have effects in deciding Contribution margin elements along with other case to case based scenarios.

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