MARGINAL CONTRIBUTION: HOW IT IS CALCULATED AND EXAMPLE - DUDAS - 2025

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 set on a gross or per unit basis. It is also known as the contribution margin or contribution in dollars per unit.

The "contribution" represents the part of the sales income that is not consumed by variable costs and, therefore, contributes to the coverage of fixed costs. This concept is one of the key building blocks of break-even analysis.

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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 sales price of products.

What is the marginal contribution?

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 sales 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.

Uses of contribution margin

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 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 values ​​of contribution margin can be observed in industrial sectors that require a lot of labor, such as manufacturing, since variable costs are higher, while high values ​​of contribution margin prevail in capital intensive sectors.

How is it calculated?

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 marginal contribution indicator is $ 8 / $ 10 = 80%.

Marginal contribution can be considered as the fraction of sales that contributes to cover 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.

Cost-volume-benefit (CVB) analysis

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.

Example

Suppose that a company owns a machine to make pens, which has a fixed cost of $ 10,000.

Making a pen requires $ 0.2 in raw materials. Another $ 0.1 goes towards 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.

Profit and 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 may increase or decrease non-linearly with the number of units sold, since it includes fixed costs.

References

1. Investopedia (2019). Contribution Margin Definition. Taken from: investopedia.com.
2. Wikipedia, the free encyclopedia (2019). Contribution margin. Taken from: en.wikipedia.org.
3. Ashok M (2019). Calculating Contribution and Marginal Costing. Accounting Notes. Taken from: accountingnotes.net.
4. Amy Gallo (2017). Contribution Margin: What It Is, How to Calculate It, and Why You Need It. Harvard Business Review. Taken from: hbr.org.
5. Harold Averkamp (2019). What is contribution margin? Accounting Coach. Taken from: accountingcoach.com.