Here you will find contribution margin definition, formula and explanation.
Contribution margin ratio allows the business to estimate and analyze profitability of separate products.
Contribution margin formula is the following:
Contribution Margin= (Revenue for Item – Variable cost of Item) / Revenue of Item
The essence of this ratio is that it does provide operating profit margin for a separate product, i.e. shows the percentage of profit for item compared to its sales revenue.
This ratio also allows to check whether variable cost per item or sales per item can be changed and how this would impact profitability of the product.
t is essential to stress that this ratio is used for the purpose of internal analysis, since it is not possible to derive such information from publicly available financial statements. Businesses never disclose their margins, as this information is very sensitive and confidential.
Also the next step would be to analyse whether contribution margin is sufficient to cover fixed costs taking into account various production levels. It is essential that profitability is sufficient to cover fixed costs and still to provide profit afterwards. For this purpose we should use not a percentage, as it I indicated in the previous formula, but absolute value of contribution margin, which is calculated as follows:
Contribution Margin = Sales Price per Item – Variable Cost per Item
This is alternative way how to calculate contribution margin ratio, allowing to compare this difference with fixed costs at different levels of production.