Contribution margin is the difference between sales revenue and variable cost.
it allows a company to determine the profitability
of individual products by measuring how sales affect profits.
In its ratio form, it is calculated as contribution margin
divided by sales revenue.
While revenue from a company's product
is how much money the company makes from selling that item,
a product's variable costs include those expenses
that vary depending on the company's production volume.
A business owner, Ida might use contribution margin figures
to decide which products costs,
he should reduce or which price he should increase.
For example, if a pair of jeans sells for $100,
and its variable costs are $65, its contribution margin is $35 or 35%.
This means that for each dollar of sales, profit increases by 35 cents.
Ida wants to see a contribution margin ratio of 50%.
He determines he can achieve this
either by reducing variable cost to $50
by increasing the price of jeans to $130,
or through some combination of the two.
Another option is to quit selling jeans entirely,
and focus on other products such as button-down shirts,
which already have a contribution margin of at least 50%.
Ida might also want to calculate the contribution margin
for all of his products in sum.
If total variable costs re $750,000, and total sales are 1.5 million dollars,
the total contribution margin in ratio form will be 50%.
The business could compare the contribution margins
of individual products against the company's total contribution margin
to determine which products to sell more of, or which to sell less off.
If dress slacks have a contribution margin of 60%,
and it is possible to sell more of them
at the same price total contribution margin will rise.