Business Model

The Unit Contribution Margin (C) is Unit Revenue (Price, P) minus Unit Variable Cost (V):

The Contribution Margin Ratio is the percentage of Contribution over Total Revenue, which can be calculated from the unit contribution over unit price or total contribution over Total Revenue:

For example, if the price is Rs10 and the unit variable cost is Rs2, then the unit contribution margin is Rs8, and the contribution margin ratio is Rs8/Rs10 = 80%.

[edit]Explanation

Profit and Loss as Contribution minus Fixed Costs.

Contribution margin can be thought of as the fraction of sales that contributes to the offset of fixed costs. Alternatively, unit contribution margin is the amount each unit sale adds to profit: it's the slope of the Profit line.

Cost-Volume-Profit Analysis (CVP): assuming the linear CVP model, the computation of Profit and Loss (Net Income) reduces as follows:

where TC = TFC + TVC is Total Cost = Total Fixed Cost + Total Variable Cost and X is Number of Units. Thus Profit is Unit Contribution times Number of Units, minus the Total Fixed Costs.

The above formula is derived as follows:

From the perspective of the matching principle, one breaks down the revenue from a given sale into a part to cover the Unit Variable Cost, and a part to offset against the Total Fixed Costs. Breaking down Total Costs as:

one breaks down Total Revenue as:

Thus the Total Variable Costs offset, and the Net Income (Profit and Loss) is Total Contribution Margin minus Total Fixed Costs:

[edit]Applications

Contribution arises in Cost-Volume-Profit Analysis, where it simplifies calculation of Net Income, and especially break even analysis.

Given the contribution margin, a manager can easily compute breakeven and target income sales, and make better decisions about whether to add or subtract a product line, about how to price a product or service, and about how to structure sales commissions or bonuses.

Contribution margin analysis is a measure of...