what is the purpose of determining the contribution margin? course hero

Analyzing the contribution margin helps managers make several types of decisions, from whether to add or subtract a product line to how to price a product or service to how to structure sales commissions. The most common use is to compare products and determine which to keep and which to get rid of.

Full Answer

What is contribution margin and why is it important?

When you run a company, it’s obviously important to understand how profitable the business is. Many leaders look at profit margin, which measures the total amount by which revenue from sales exceeds costs. But if you want to understand how a specific product contributes to the company’s profit, you need to look at contribution margin.

How do you calculate the contribution margin?

It’s a simple calculation: Contribution margin = revenue − variable costs For example, if the price of your product is $20 and the unit variable cost is $4, then the unit contribution margin is...

Should you use contribution margin to calculate fixed cost allocation?

But you shouldn’t use contribution margin­, or any measure of profit, exclusively; you should consider the fixed cost allocation as well. Take a company’s cash cows, a term coined by the Boston Consulting Group to describe products that provide a steady income or profit.

Is it worth keeping a product with a negative contribution margin?

If a product’s contribution margin is negative, the company is losing money with each unit it produces, and it should either drop the product or increase prices. If a product has a positive contribution margin, it’s probably worth keeping.

What is the most common use of a product's contribution margin?

The most common use is to compare products and determine which to keep and which to get rid of. If a product’s contribution margin is negative, the company is losing money with each unit it produces, and it should either drop the product or increase prices.

How does a company's income statement work?

Think about how company income statements usually work: You start with revenue, subtract cost of goods sold (COGS) to get gross profit, subtract operating expenses to get operating profit, and then subtract taxes, interest, and everything else to get net profit.

Is a positive contribution margin worth keeping?

If a product has a positive contribution margin, it’s probably worth keeping. According to Knight, this is true even if the product’s “conventionally calculated profit is negative,” because “if the product has a positive contribution margin, it contributes to fixed costs and profit.”.