Contribution margin or contribution is the difference between the sales and the marginal cost of sales. It contributes towards the fixed cost and profit elements.
Let’s say the selling price per unit is $15, the variable cost per unit is $10 and the fixed cost is $150,000. Here the contribution per unit will be $5 (i.e. selling price – variable cost; $15-$10). $150,000 is the contribution for $30,000 units ($150,000/$5). It is sufficient to meet the fixed costs of $150,000 but no margin for profits is left.
There are many alternatives to computing the contribution margin. We can use and apply any of the given three formulae. The result will be the same:
Contribution = Selling Price – Marginal Cost
For example, if the selling price per unit is $10 and Variable Costs are worth $7, the contribution margin will be $3. This $3 includes the fixed cost per unit + the profit per unit.
Contribution = Fixed Expenses + Profit/(Loss)
If noticed carefully, it is just change in the equation. Here also the contribution margin is the sum of fixed costs along with profit or loss.
Contribution – Fixed Expenses = Profit/(Loss)
It is again, nothing more than a change in the equation. However, using this formula we get the value of profit or loss and it is assumed that we have already computed the contribution margin.
In marginal costing, the contribution is very important as it helps to find out the profitability of a product, department or division, to have a better mix of the products or for better profit planning.
Here it needs to be understood that the contribution margin is not the profit and it is different from the profit. The profit or surplus is the net gain and is arrived after deducting fixed cost/expenses from the total contribution. Cost accountants find the contribution margin as the true representative of actual profit.