In any retail or manufacturing business, it is important to know how much each unit sold contributes to the business's profit. This is commonly referred to as the "contribution margin." This is part of cost volume profit analysis, a management accounting technique that allows businesses to understand their profit levels at varying levels of production. By calculating the contribution margin, a manager can determine which products are most profitable and make production decisions accordingly. It is easy to calculate the profit contribution of a product by following several basic steps.
Write down the unit price. This is the price at which each unit is sold; it is not the unit cost or the unit profit.
Calculate the unit variable cost. This is calculated by first determining the total variable costs for all the products. Variable costs are all the costs that increase proportionately to an increase in production. They include material costs, direct labour costs and any other costs that increase as production increases. Variable costs include all costs that are not fixed costs, such as equipment, indirect labour and real estate. Add all of the variable costs and divide the total by the number of units produced. This will give you the unit variable cost. Write this number down.
Subtract the unit variable cost from the unit price. This figure gives you the contribution margin of each unit, which tells you how much one unit contributes to the profit. Write down the unit contribution margin. For example, if your unit price is £3 and your unit variable cost is £1.30, then each unit that you produce will contribute £1.90 toward profits.
Multiply the unit contribution margin by the number of units produced. This will give you the total contribution margin for all units. This is useful if you want to know how much your total production is contributing to profits.
Profit contribution is a tool intended to help make management decisions. You should use the information that you calculate to make recommendations for the business, such as increasing production, ending production of a product with a low contribution margin or reducing variable costs to achieve a higher profit contribution.
The contribution to profit does not necessarily mean that there is a profit. The contribution first must cover fixed costs. Only after covering fixed costs, or reaching the break-even point, will a profit actually be made. Knowing the contribution margin is essential for calculating the break-even point.