The Contribution margin is the most basic of all financial measures, and is basically trying to determine the profitability of individual products and/or whole product lines. The contribution margin discovers how much capital is left after subtracting direct variable costs, which can be used to cover fixed costs and generate profits.
Variable costs are costs that can be directly coupled to the production of products or services.
Variable costs could e.g. be:
Direct labor costs
Costs of goods sold
Fixed costs could e.g. be:
Below, the formulas for contribution margin and contribution margin ratio are presented
Contribution Margin = Sales - Variable costs
Contribution Margin Ratio
Contribution Margin Ratio = Contribution margin / Sales
Example: Company X sells a product for $1000, and the products variable costs are $250, then company X gets a contribution margin of $750. The contribution margin ratio will then be $750/ $1000 = 75%.
When analyzing contribution margin and contribution margin ratios, business leaders can evaluate if e.g. a certain product or product line performs satisfactorily. If the contribution margin is too low, business leaders can seek to minimize variable costs, or try to raise the selling price of the product. If none of the options are feasible, companies may terminate the production of products showing an unsatisfactory contribution margin.