What is the contribution margin?

The concept of contribution margin is the difference between the sales price minus the variable costs. The definition of contribution margin is also considered the excess of income in relation to variable costs, an excess that must cover fixed costs and profit.

Contribution margin elements

The contribution margin is made up of different elements that we must analyze:

  • Fixed costs: those costs that remain constant over time, regardless of the production volume. Example: renting a premises.
  • Variable costs: costs that vary based on the volume of production. This implies that if there is no production, there are no variable costs, and if production grows, so will the variable cost. Example: materials.
  • Profit: refers to the percentage that the product wants to obtain on the invested cost (fixed cost + variable cost)

Contribution margin example

The formula is very simple, since only the unit variable cost must be subtracted from the unit sale price. To better understand this concept we are going to use an example. If a company manufactures 10.000 sneakers per month, which sells for 10 euros each, the monthly sales volume will be 100.000 euros. The two employees you have are paid a wage of 4.000 euros between the two. For their part, costes of raw material amount to 5 euros per shoe, which is 50.000 euros per month.

Therefore, the operation to obtain the contribution margin would be: 100.000 - 50.000.

Thanks to the contribution margin, it is possible to know how much a specific product is contributing to the company's coffers. Thus you can identify to what extent it is profitable or not to continue with your production.

When the contribution margin is positive, the fixed cost and generates a higher profit margin. If it is equal to the fixed cost, there will be no possibility of profitabilityWhile if the contribution margin does not reach to cover the fixed costs, the company can continue working, but if it does not take measures it runs the risk of running out of sufficient working capital, since it would be used to meet the fixed costs.

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