Learning Outcomes
- Outline the contribution margin model
As we delve deeper into the CVP analysis, we need to note how much each additional product we sell brings to the contribution margin for the company.
Contribution margin is defined as the sales less the variable expenses.
[latex]\text{sales}-\text{variable expenses}=\text{contribution margin}[/latex]
When we calculate the contribution margin, we ignore the fixed costs. We are simply looking at how much each additional item we sell, contributes to the funds available for use by the company. This contribution margin is used first to pay fixed expenses, such as rent and administrative overhead. Any dollars left over after covering the fixed expenses contributes to profits.
So if we go back to the previous examples our contribution margins would be as follows:
| Sales 100 units x $3 per unit = $300 |
| Variable cost per unit = 100 units x $1 per unit= $100 |
| Contribution margin = ($300- $100)= $200 |
| Sales =70 units x $3 per unit = $210 |
| Variable Costs per unit= 70 units x $1 per unit= $70 |
| Contribution margin = ($210- $70)= $140 |
So you can see from these examples, what we have left to cover our fixed expenses. If we sell 100 units, we have $200 left, after covering the variable costs to cover our fixed expense. If we only sell 70 units, we have $140 remaining to cover these expenses. We can start to see the importance of pricing effectively and keeping our costs under control as we look at making sure our company shows a profit.
Practice Questions
