Contribution Margin: Definition & Formula

Lesson Transcript
Instructor: Tara Schofield

Tara received her MBA from Adams State University and is currently working on her DBA from California Southern University. She spent 11 years as a sales and marketing executive. She spent several years with Western Governor's University as a faculty member. Tara has been at for seven years.

The contribution margin is the selling price of a product less the variable cost per unit. It's also an indicator of how much more is needed to cover the fixed expenses. Calculate contribution margin in the examples provided after learning the definition and formula. Updated: 10/15/2021

Definition of Contribution Margin

The contribution margin is a very important number in a company's financial reporting. It is the number that tells you if all of the variable costs are covered and how much is left to cover the fixed expenses.

This number is often evaluated on a division or department basis. For instance, if your company has several divisions, each group's contribution margin either helps or detracts from the company's ability to cover fixed costs. When a department is profitable, it will have sufficient revenue to cover the variable expenses and a remainder of income as contribution margin. If a department does not have enough to cover their expenses, it will have a negative contribution margin and will not be profitable.

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Example of Contribution Margin

Let's look at a hypothetical situation to better understand contribution margin. Say that you're managing a hotel, and several areas of the business have the potential to earn money and add to the contribution margin. The restaurant earns enough to cover the food, labor, and restaurant expenses, and there is money left over to put towards the fixed expenses of the hotel. At the same time, the hotel is charging for rooms and can contribute towards the hotel's expenses after the variable costs, like laundry, housekeeping payroll, and cleaning supplies are deducted. You also have conference rooms you rent that earn a sizable amount of income beyond the expenses to maintain them. You may even have valet and parking revenue that exceeds the expenses of hiring valet drivers and parking costs.

Because you are an excellent manager, you are able to increase earnings in each of these areas so that all of the expenses for each division are covered and there is ample left over. Here, the leftover earnings are the contribution margin. It is the money that goes towards covering the fixed costs of the business and the net profit of the company.

Calculating Contribution Margin

Now that we have a better grasp of contribution margin, let's learn how to calculate it. The contribution margin is calculated by subtracting the variable costs from the gross revenue. In other words, the formula is:

contribution margin = gross revenue - variable costs

Let's return to our hotel example, look at the divisions, and calculate the contribution margin.

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