The marginal contribution represents the incremental money generated by each product or unit sold after deducting the variable part of the company's costs. It can be established on a gross basis or per unit. Also known as contribution margin or contribution in dollars per unit.
The “contribution” represents the part of the sales income that is not consumed by the variable costs and, therefore, contributes to the coverage of the fixed costs. This concept is one of the key building blocks of break-even analysis..
In cost-volume-profit analysis, a form of management accounting, the contribution margin (the marginal profit per unit of sale) is a useful quantity for various calculations and can be used as an indicator of operating leverage..
The marginal contribution is the basis for the break-even analysis, used in the general planning of the cost and sale price of products.
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Marginal contribution indicates how a particular product contributes to the overall profit of the business. Provides a way to show the earning potential of a particular product offered by a company. Shows the portion of sales that helps cover the company's fixed costs.
Any remaining income left after covering fixed costs is the profit generated.
The contribution margin helps separate the fixed cost component from the profit from product sales.
It can be used to determine the range of a product's selling price, the level of profit that can be expected from sales, and to structure sales commissions paid to sales team members, distributors or commission agents.
The marginal contribution can help management select among several possible products, competing to use the same set of manufacturing resources..
Let's say a company has a pen-making machine, which is capable of producing both pens and ballpoint pens, and management must make the decision to produce only one of them..
If the contribution margin of a pen is higher than that of a ballpoint pen, preference will be given to producing it, due to its greater potential for profitability. Such decision making is common in companies that manufacture a diversified portfolio of products..
Very low or negative contribution margin values indicate economically unviable products, the manufacture and sale of which should be discarded.
Low contribution margin values can be observed in labor-intensive industrial sectors, such as manufacturing, as variable costs are higher, while high contribution margin values prevail in capital intensive sectors..
It is calculated as the difference between the selling price of a product and the variable costs associated with its production and sales process.
Unit Marginal Contribution = Selling Price - Variable Cost per Unit.
The above formula is also used as an indicator, to arrive at an answer in percentage terms.
The marginal contribution indicator is the percentage of contribution on sales income. It can be calculated from the unit tax on the unit price, or the total tax on the total income:
Marginal contribution indicator =
Unit Marginal Contribution / Selling Price =
(Sales price - Variable cost per unit) / Sales price =
(Sales revenue - Total variable costs) / Sales revenue.
For example, if the price is $ 10 and the unit variable cost is $ 2, then the marginal contribution per unit is $ 8, and the indicator of marginal contribution is $ 8 / $ 10 = 80%.
The marginal contribution can be considered as the fraction of sales that contributes to cover the fixed costs. Alternatively, the unit marginal contribution is the amount that each unit sale adds to the profit: it is the slope of the profit line.
Assuming the linear CVB model, the calculation of the net profit (or loss) is reduced as follows:
Net Profit = Total Income - Total Cost, where
Total revenue = Sales price * Units sold = P * U.
Total cost = Total variable cost + Total fixed cost = CVT + CFT. Then you have to:
Net profit = P * U - (CVT + CFT) = (P * U - CVT) - CFT
= Total marginal contribution - CFT.
Therefore, the net profit (or loss) is the total marginal contribution minus the total fixed cost.
Suppose a company owns a machine for making pens, which has a fixed cost of $ 10,000.
Making a pen requires $ 0.2 in raw materials. Another $ 0.1 goes to the cost of electricity to run the machine to produce a pen, and $ 0.3 is the labor cost to make a pen. These three components constitute the unit variable cost, which will be: ($ 0.2 + $ 0.1 + $ 0.3) = $ 0.6 per unit.
If a total of 100 pens are manufactured, the total variable cost will be ($ 0.6 * 100 units) = $ 60, while manufacturing 10,000 pens will result in a total variable cost of ($ 0.6 * 10,000 units) = $ 6,000.
These variable costs increase in direct proportion to the number of units manufactured.
However, the production of pens will be impossible without the production machine, which has a fixed cost of $ 10,000..
This cost of the machine represents a fixed cost, and not a variable cost, since its cost does not increase according to the units produced. This fixed cost is not considered in the calculation of the marginal contribution..
If a total of 10,000 pens are manufactured using the machine, at a variable cost of $ 6,000 and a fixed cost of $ 10,000, the total manufacturing cost will be $ 16,000.
The unit cost will be calculated as $ 16,000 / 10,000 = $ 1.6 per unit. If each pen is sold at a price of $ 2 per unit, the unit profit would be:
(Sales Price - Unit Cost) = ($ 2.0 - $ 1.6) = $ 0.4 per unit.
However, the marginal contribution does not take into account the fixed cost component, considering only the variable cost component. The profit obtained for each unit sold, as represented by the contribution margin, will be:
(Sale Price - Unit Variable Cost) = ($ 2.0 - $ 0.6) = $ 1.4 per unit.
A key feature of the marginal contribution is that it remains fixed on a unit basis, regardless of the number of units sold..
On the other hand, the net profit per unit can increase or decrease in a non-linear way with the number of units sold, since it includes fixed costs..
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