Definition: Contribution margin is a financial metric that offers insights into how much of how much revenue is left after taking into account variable cost, which can be used to cover fixed cost and contribute to overall profits. A clear understanding of the contribution margin can help business make informed decisions about the pricing strategies, product offerings and resource allocation.

 

Components of Contribution Margin:

 

1. Sales/ Revenue: Sales or also referred to as revenue represent the total money generated from sale of goods during a specific period. It is the primary source of income for companies and it is the top line figure in the income statement. It is the total value of goods before deducting necessary expenses such variable and fixed cost, and administrative expenses.

2. Varibale Cost: Variable costs are expenses that are directly related to the production or delivery of goods and services. These costs included raw materials, direct labor, direct materials and variable overhead costs.

Formula:

 

Sales - Variable Cost = Contribution Margin

Note: This computation quantifies the amount of revenue available to cover fixed costs and contribute to profit generation.

 

Interpretation:

A higher contribution margin indicates a greate profitability and a stronger ability to cover fixed costs.

A lower contribution margin indicates inefficiencies or challenges in the production or pricing process.

Note: This computation quantifies the amount of revenue available to cover fixed costs and contribute to profit generation.

 

(Contribution Margin/ Sales) x 100% = Contribution Margin Ratio

Note: this ratio indicates how much each dollar of sales contributes to covering fixed costs and generating profits.

 

 

Importance:

A. Pricing Decisions

 Contribution margin analysis assists firms in determining prices for products or services that maintain profitability while being competitive in the market.

 

B. Product Mix Optimisation

By examining contribution margins for various products or services, organizations can optimize their product mix to focus on those that have the greatest impact on total profitability.

 

C. Resource Allocation

 Contribution margin analysis directs resources to products or services with better profit potential

 

 

PRACTICE QUESTIONS

 

THEORY 

 

1. Which of the following best defines contribution margin?

A) Total revenue minus total variable costs

B) Total revenue minus total fixed costs

C) Total revenue minus total variable and fixed costs

D) Total variable costs minus total fixed costs

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2. What does the contribution margin ratio indicate?

A) The percentage of sales revenue that contributes to covering fixed costs

B) The percentage of variable costs in relation to total costs

C) The percentage of gross profit in relation to total revenue

D) The percentage of net income in relation to total revenue

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3. How does an increase in the contribution margin affect a company's breakeven point?

A) The breakeven point increases

B) The breakeven point decreases

C) The breakeven point remains unchanged

D) The breakeven point becomes negative

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4. Which of the following statements is true regarding contribution margin analysis?

A) It only considers variable costs and ignores fixed costs.

B) It provides insights into the profitability of individual products or services.

C) It is not useful for pricing decisions.

D) It is primarily used for financial reporting purposes.

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5. In contribution margin analysis, what does a negative contribution margin indicate?

A) The company sales is not sufficient to cover the variable costs.

B) The company is covering fixed costs but not generating any profit.

C) The company's variable costs exceed its total revenue.

D) The company's fixed costs exceed its total revenue.

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PROBLEMS:

 

1. The TJP Company currently has a contribution margin of $95 per unit. It is considering increasing sales salaries from $13 per unit to $17 per unit and decreasing administrative expenses from $15 per unit to $12 per unit. If both of these changes are implemented, what will be TJP's new contribution margin per unit?

A. $95 per unit

B. $94 per unit

C. $91 per unit

D. $98 per unit

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2. MC Corporation sells headphones that have a selling price of $200 and a contribution margin ratio of 0.4. Variable costs are expected to increase $10 a unit next year with no change to the selling price. Calculate the new contribution margin ratio.

A. 0.60

B. 0.35

C. 0.40

D. 0.55

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3. Breeze Company has a contribution margin of $4,000 and fixed costs of $1,000. If the total contribution margin increases by $1,000, operating profit would:

A. Increase by more than $1,000

B. Remain unchanged

C. Decrease by $1,000

D. Increase by $1,000

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4. Based on the following information from ABC Corporation, calculate ABC's contribution margin per unit.

Selling price per unit $100

Direct materials per unit $20

Direct labor per unit $15

Variable manufacturing overhead per unit $10

Fixed manufacturing overhead per unit $18

Sales commissions per unit $9

Fixed selling costs per unit $12

A. $37 per unit

B. $46 per unit

C. $16 per unit

D. $55 per unit

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5. BrewCo sells coffeemakers for $120 each. The firm currently has variable costs per unit of $65. If BrewCo is able to reduce its variable cost per unit to $58, its contribution margin ratio will:

A. Decrease by about 8%.

B. Increase by about 8%.

C. Decrease by about 6%.

D. Increase by about 6%

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ANSWER KEY 

THEORY 

1. A

2. A

3. B

4. A

5. A

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PROBLEMS 

1. A

2. B

3. D

4. B

5. D

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Reference: Dakay (2024). CVP Analysis. RCMA Review Handouts