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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.
The total gross income from room rentals last year was $500,000. You were very effective in managing costs and were able to keep all room-related variable expenses (housekeeping staff, cleaning supplies, linens, repairs, etc.) down to $250,000. After the variable expenses are subtracted, you see you have a contribution margin of $250,000.
The restaurant and bar generated $1,200,000 in revenue and had variable expenses of $800,000 (this includes food, alcohol, entertainment, wait and cooking staff, supplies, etc.). The restaurant has $400,000 that goes towards the profit margin.
Finally, you were able to grow the conference business, and it created $1,500,000 in revenue. After all of the variable expenses of $700,000 were deducted, you're pleased to see that the conference room division has $800,000 remaining.
When all of these amounts are added together, your total contribution margin for the hotel is $1,450,000. The contribution margin allows for all of the fixed costs to be paid, including the hotel mortgage, administrative expenses and payroll, debt payments, and other expenses. Because these expenses are substantial, $1,200,000 of the contribution margin is needed to meet these obligations. Thus, the remaining amount, $250,000, is considered net profit.
The contribution margin is an important number to understand when reviewing the financial status of a company, especially when many divisions are considered. It's helpful in comparing which areas of a business are profitable and which are not. The contribution margin is the amount of excess or remainder income that is applied to the company's fixed expenses and net income.
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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Contribution Margin: Definition & Formula
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