What is Contribution Margin?
The contribution margin formula is used to calculate contribution margin. Contribution margin is the difference between the revenue and the variable costs of a business.
The contribution margin formula is written as follows:
Sales Revenue used in CM Formula
In accounting sales revenue refers to the monetary amount from the sale of goods and services in which the business normally trades and which were bought for the purpose of resale. Sales returns and allowances, and sales discounts are deducted to arrive at the sales revenue figure to use in the contribution margin formula calculation.
Variable Costs used in CM Formula
Variable costs are those costs which vary in relation to the activities carried out by the business. One example of a variable cost is the cost of goods sold which is the costs associated with producing the goods which have been sold during an accounting period.
Rearranging the Contribution Margin Formula
The contribution formula can be rearranged in numerous ways to provide useful information depending on what information is already known.
For example, if you only know the variable costs and the contribution margin ratio, you can calculate the revenue and the contribution margin using the margin formula.
The table below shows a few ways of rearranging the contribution formula.
|Formula used to||Formula|
|Calculate contribution margin||CM = R – VC|
|Calculate revenue||R = VC + CM|
|Calculate variable costs||VC = R – CM|
|Calculate contribution margin ratio||CM% = CM / R = (R – VC) / R|
|Calculate revenue||R = VC / (1- CM%)|
Example of how to use the Contribution Margin Formula
Suppose a business knows that its variable costs are 200,000 and its contribution margin percentage is 40% and wants to find its contribution margin.
The margin formula tells us that Revenue = Variable costs + Contribution margin. So if contribution margin is 40% of revenue, then variable costs must be the remaining 60% of revenue. This is demonstrated in the diagram below.
If variable costs are 60% of revenue it follows that:
Variable costs = 60% x Revenue Revenue = Variable Costs / 60% = 200,000 / 60% = 333,333
Finally using the CM formula again
Contribution Margin = Revenue - Variable Costs Contribution Margin = 333,333 - 200,000 = 133,333
To check that this is correct we can calculate the contribution margin ratio as follows.
Contribution Margin Ratio = (Revenue - Variable Costs) / Revenue Contribution Margin = (333,333 - 200,000) / 333,333 = 40%
The CM formula is very useful for calculating the contribution of a business. The contribution margin is an important concept as it represents the true income of a business as it shows the income left after deducting variable costs which is available to pay the operating expenses of the business.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.