Contribution Margin

Every sale first has to pay for its own variable costs, such as materials and commissions. What is left over, the contribution margin, goes towards covering fixed costs like rent and salaries. Once fixed costs are covered, each additional unit's contribution becomes profit.

For example, a product sells for 50 and has variable costs of 30 per unit. Its contribution margin is 20 per unit. If the business sells 1,000 units, the total contribution is 20,000. If fixed costs are 15,000, profit is 5,000.

Contribution margin is a powerful tool for decision-making. It shows which products contribute most towards fixed costs, helps set minimum prices for special orders and is used to calculate break-even points. In the example, the business needs to sell 750 units to cover its fixed costs of 15,000.

Products with a high contribution margin are especially valuable when capacity is limited. A business may choose to promote products that contribute most per unit of a scarce resource, such as machine time or shelf space.

Contribution margin can also be expressed as a percentage of the selling price, called the contribution margin ratio.