Definition: Contribution margin is the amount of sales revenue that exceeds variable costs. In other words, this is the amount of revenue that can be used to pay for fixed costs after all of the variable costs have been paid.
The contribution margin formula is calculated by subtracting variable costs from total sales revenue. Both management and external users use this ratio to analyze the business performance.
What Does Contribution Margin Mean?
Management uses this ratio to improve internal operations and make business and market decisions. For example, management often uses the contribution margin calculation to make pricing decisions. Sometimes it’s impossible to raise prices even to break even, especially when the business is growing. Using this formula, management can calculate the amount of fixed expenses that won’t be covered by operations and will need to be funded by investors, creditors, or retained earnings.
Investors typically use this ratio to evaluate a business’ health and long-term sustainability. If the contribution margin doesn’t excess the fixed costs, it shows investors that the company’s operations aren’t funding its costs and could have long-term problems if things don’t turn around.
Remember, this is an operational ratio. It deals with sales revenue and variable costs. Other income is not included. This means a company could have a positive margin too small to pay for its fixed costs and still show net income on the income statement because of non-operating activities.
Let’s take a look at an example.
Steve’s Sign Company manufactures retail storefront signs and has sales of $100,000 for the year. Steve has variable costs of $75,000. Thus is margin is $25,000 ($100,000 – $75,000).
We can take this a step further and turn it into a ratio by dividing the margin by the sales revenues. This shows us that 25 percent of the revenues are available to pay for fixed costs ($25,000 / $100,000).