- What is contribution margin
- Visual map of the product mix by contribution margin
- Contribution margin formula
- Example: three products and one limited machine
- Best mix with a limited resource
- Decision: should you drop the product that shows a loss?
- Variable costing vs absorption costing
- Common mistakes
- Frequently asked questions
What is contribution margin
Contribution margin is what remains of the selling price after deducting the variable costs and expenses of the product. It is the amount each unit sold "contributes" toward fixed costs and profit.
Variable costing (direct costing) is the method built on this idea: only costs that change with volume go into the product, while fixed costs are treated as a lump for the period. It answers decision questions well: which product to prioritize, whether to accept a special order, or whether to drop an item. For the volume where the margin covers fixed costs, see break-even.
Visual map of the product mix by contribution margin
The map shows the formula, the three example products and the priority order by margin per machine hour.
Contribution margin formula
Unit CM = selling price − unit variable costs and expenses
CM ratio = unit CM ÷ selling price
Typical variable items: raw material, packaging, process energy, sales commission and freight. Direct labor only counts if it varies with output (for example, piece-rate pay). Rent, depreciation and overhead salaries are fixed. To separate the components, see the production cost calculation.
Example: three products and one limited machine
Fictional example. A plant has 1,200 machine hours per month and fixed costs of $30,000. Data per product:
| Product | Price | Variable | Unit CM | CM ratio | Hours per unit | Demand |
|---|---|---|---|---|---|---|
| A | $50.00 | $30.00 | $20.00 | 40% | 0.5 h | 1,000 |
| B | $80.00 | $56.00 | $24.00 | 30% | 0.8 h | 600 |
| C | $40.00 | $22.00 | $18.00 | 45% | 0.3 h | 800 |
Calculations: A = 50 − 30 = 20, and 20 ÷ 50 = 40%. B = 80 − 56 = 24, and 24 ÷ 80 = 30%. C = 40 − 22 = 18, and 18 ÷ 40 = 45%. Product B has the highest CM per unit but the lowest ratio. To compare when a resource is scarce, the right criterion is CM per hour of the limiting resource.
Best mix with a limited resource
Total demand needs 1,000×0.5 + 600×0.8 + 800×0.3 = 1,220 hours, but only 1,200 exist. Capacity is short, so you must choose.
CM per hour = unit CM ÷ hours per unit
| Product | Calculation | CM per hour | Priority |
|---|---|---|---|
| C | 18 ÷ 0.3 | $60.00 | 1st |
| A | 20 ÷ 0.5 | $40.00 | 2nd |
| B | 24 ÷ 0.8 | $30.00 | 3rd |
Allocate by priority: C makes 800 units (240 h), A makes 1,000 (500 h), leaving 460 h for B, which makes 460 ÷ 0.8 = 575 units (25 short of demand).
| Product | Units | Hours | Total CM | Allocated fixed | Result |
|---|---|---|---|---|---|
| A | 1,000 | 500 h | $20,000 | $8,000 | $12,000 |
| C | 800 | 240 h | $14,400 | $7,000 | $7,400 |
| B | 575 | 460 h | $13,800 | $15,000 | −$1,200 |
| Total | 2,375 | 1,200 h | $48,200 | $30,000 | $18,200 |
If priority followed unit CM, B would come first: 600 units (480 h), A 1,000 (500 h) and C with 220 ÷ 0.3 = 733 units. Total CM would fall to 14,400 + 20,000 + 13,194 = $47,594, which is $606 less. With more than one limited resource, use linear programming; to find the resource that holds the plant back, see the theory of constraints and the production capacity calculation.
Decision: should you drop the product that shows a loss?
In the table, product B shows a result of −$1,200 because it received $15,000 of allocated fixed costs. But its CM is positive at $13,800. If the fixed costs remain without it, dropping it makes the result worse:
| Item | With B | Without B |
|---|---|---|
| Contribution margin | $48,200 | $34,400 |
| Fixed costs (unchanged) | $30,000 | $30,000 |
| Result | $18,200 | $4,400 |
The rule: a product covers its share if CM is positive and the fixed costs are unavoidable. Dropping makes sense only if its fixed costs are avoidable (an extra shift that goes away, a contract that ends) or if the freed capacity goes to a product with higher CM per hour. The same logic applies to a special order: accept it if the price is above variable cost and there is idle capacity, without pulling down prices for regular customers. The volume needed shows up in break-even: with an average CM ratio of 37.7% (48,200 ÷ 128,000), break-even is 30,000 ÷ 0.3766 ≈ $79,668 of revenue.
Variable costing vs absorption costing
Under absorption costing, fixed costs are allocated to products, and each product's result depends on the allocation basis. Under variable costing, the statement looks like this:
| Line | Amount |
|---|---|
| Revenue | $128,000 |
| (−) Variable costs and expenses | $79,800 |
| (=) Contribution margin | $48,200 |
| (−) Fixed costs | $30,000 |
| (=) Result | $18,200 |
Variable costing serves internal management. External financial reporting and tax rules generally require absorption costing, so many companies keep both reports.
Common mistakes
- Classifying fixed cost as variable (or the reverse): energy and labor often have a fixed and a variable part. Separate the part that moves with volume.
- Ranking by unit CM with a scarce resource: use CM per hour of the bottleneck.
- Dropping a product based on the post-allocation result: allocation is arbitrary, and a positive CM pays fixed costs.
- Ignoring demand and market limits: the mix is only valid as far as there are orders.
- Using list price: use net price after discounts, sales taxes and commissions.
- Treating CM as profit: it becomes profit only after covering fixed costs.
Frequently asked questions
How do you calculate contribution margin?
Selling price minus unit variable costs and expenses. In the example, product A: 50 − 30 = $20.00.
What is the difference between contribution margin and profit?
Contribution margin is before fixed costs. Profit is total margin minus fixed costs: 48,200 − 30,000 = $18,200.
What is the contribution margin ratio?
Unit CM divided by price. For product A, 20 ÷ 50 = 40%.
When should I use CM per machine hour?
When a resource (machine, labor) limits output. Prioritize the product with the highest CM per hour: C, at $60.00 per hour.
What if contribution margin is negative?
If the price is below variable cost, each sale adds to the loss. Raise the price, cut variable cost or stop producing.
Does variable costing replace absorption costing?
No. Variable costing supports internal decisions. For financial and tax statements, absorption costing is generally used.
Sources
- HORNGREN, C. T.; DATAR, S. M.; RAJAN, M. Cost Accounting: A Managerial Emphasis. Pearson.
- GARRISON, R. H.; NOREEN, E. W.; BREWER, P. C. Managerial Accounting. New York: McGraw-Hill.
- GOLDRATT, E. M.; COX, J. The Goal. Great Barrington: North River Press.
Keep studying: trusted sources and links
- Sebrae PR: preço de venda, como calcular (in Portuguese)
- Sebrae: gestão, custos e finanças para empresas (in Portuguese)
- Wikipedia: Cost accounting
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About the author
Lean Manufacturing & Behavioral Management Specialist
Over 20 years in the automotive and metalworking industries (GM and Dana), Lean Manufacturing practitioner since 2006. SENAI instructor and mentor in Brazil’s Brasil Mais Produtivo program, delivering consulting, training and audits for 50+ companies, combining quality, productivity and people development.
