The contribution margin concept is useful for deciding whether to allow a lower price in special pricing situations, should we say, a discount, a sale in place, or any deduction in selling price.
If the contribution margin at a particular price point is excessively low or negative, it would be unwise to continue selling a product at that price. it is a critical tool to determine the selling price.
The contribution margin concept can be applied throughout a business, for individual products, product lines, profit centers, subsidiaries, distribution channels, sales by customer, and for an entire business.
When using this measurement, be aware that the contribution margin does not account for the impact of a product on the bottleneck operation of a company. A low contribution margin may be entirely acceptable, as long as it requires little or no processing time by the bottleneck operation.
To calculate the contribution margin, subtract all variable costs of a product from its revenues, and divide by its net revenue. Product variable costs typically include, at a minimum, the costs of direct materials and sales commissions. The calculation is:
(Net product revenue - Product variable costs) ÷ Product revenue
The ABC Tools Shop sells some equipment sets to SYS Garage. In the most recent period, it sold $1,000 of equipment that had related variable costs of $400. ABC Shop had $660 of fixed costs during the period, resulting in a loss of $60.
Variable expenses $ 400
Contribution margin $ 600
Fixed expenses $ 660
Net loss ($ 60)
ABC Shop’s contribution margin is 60%, so if it wants to break even, it needs to either reduce its fixed expenses by $60 or increase its sales by $100 (calculated as $60 loss divided by 60% contribution margin).
Now we know why we are not offered to upsize our burger instead of our fries and drink, right? yup exactly, because burger has lower contribution margin
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