The contribution margin can assist companies in making decisions, determining their break-even point, and understanding the effect their costs have on their profits.
An organization must determine how much each of its products and services costs to produce. Once the managers of the organization have this information, they consider how to change the company's product line or its processes to become more profitable. The contribution approach is an important one used during costing, because it can help managers figure out how much the company must sell in order to exceed its fixed costs and make a profit. A company's contribution margin is the amount remaining after a company's total variable costs are subtracted from its total sales for a given period.
The contribution margin, in other words, "contributes" toward covering fixed expenses—and also toward profits. Using this approach further reinforces the practice of properly and consistently categorizing a company's costs as either fixed or variable. If this is not done accurately, the contribution margin will be inaccurate between periods and will provide no real value to managers when they are setting budgets and long-term goals. After a company determines its contribution margin, it subtracts its fixed costs from the contribution margin to determine its net profit or net loss.
Interpreting Contribution Margin
|Contribution Margin||What It Means||Manager Action|
|Large||The company is making a significant sum on each product and service it sells.||Managers may consider whether to reallocate resources to the products and services that offer the highest contribution margins.|
|Small||The company is profiting only a small amount on each product and service that it sells.||Managers may review ways to reduce costs or consider increasing the sales price to find ways to improve contribution margin.|
|Negative||The company is losing money every time it sells the product or provides a service.||Managers may decide to stop producing the product or providing the service and allocate those resources to a segment with a positive contribution margin.|
In summary, the contribution margin provides a company with a greater perspective on its profitability. It is key to note that when a contribution margin is negative, managers may decide to eliminate that segment and allocate resources to a segment with a positive contribution margin. However, companies may also consider lowering their costs to fix a negative contribution. This can be done by using cheaper raw materials, negotiating with vendors for lower raw materials prices, finding new vendors, or some combination of these.
The most important thing to remember about the contribution margin is: the higher the contribution margin is, the more profitable a company will likely be.The contribution approach is most helpful in determining a company's break-even point. The break-even point is the point at which a company's total revenue is equal to its total cost, which means zero profit and zero loss. For a nonprofit organization, "breaking even" is actually the ideal scenario. It is not an ideal scenario for for-profit companies, but it is better than incurring a loss.
Organizations using the contribution margin approach put items in a different order on an income statement than companies that use the traditional approach. For instance, for a company using the contribution margin approach, all variable expenses that are categorized as selling, general, and administrative expenses go near the beginning of the income statement and are included in the calculation of the contribution margin.