Investopedia Video: Contribution Margin

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 ÷ 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.

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.