Contribution Margin
The amount remaining from sales revenue after variable costs are subtracted, contributing to covering fixed costs and profit.
Contribution Margin is the amount remaining from sales revenue after deducting all variable costs, which contributes towards covering fixed costs and generating profit. In manufacturing, understanding contribution margin helps make critical decisions about pricing, product mix, and which orders to accept or reject.
The Formula
Contribution Margin = Sales Price - Variable Costs
Contribution Margin Ratio = (Contribution Margin / Sales Price) × 100
Understanding Variable vs Fixed Costs
Variable Costs change with production volume:
- Raw materials and components
- Direct labor (wages tied to production)
- Packaging materials
- Power consumption during production
- Consumables (cutting tools, drill bits, welding gas)
- Freight and transportation costs
Fixed Costs remain constant regardless of production volume:
- Factory rent
- Salaries of permanent staff (managers, supervisors)
- Machine depreciation
- Insurance premiums
- Property taxes
Real Manufacturing Example
Product: Aluminum window frame
Selling Price: ₹1,500 per unit
Variable Costs per Unit:
- Aluminum extrusion: ₹450
- Paint & powder coating: ₹120
- Hardware (hinges, locks): ₹180
- Direct labor: ₹150
- Power consumption: ₹40
- Packaging: ₹30
Total Variable Cost: ₹970
Contribution Margin = ₹1,500 - ₹970 = ₹530 per unit
Contribution Margin Ratio = (₹530 / ₹1,500) × 100 = 35.3%
This means for every window frame sold, ₹530 is available to cover fixed costs (rent, salaries, etc.) and profit. If monthly fixed costs are ₹2,12,000, the factory needs to sell at least 400 units (₹2,12,000 ÷ ₹530) to break even.
Using Contribution Margin for Decisions
Scenario 1: Special Order Pricing
A builder offers bulk order of 500 window frames but only willing to pay ₹1,200 per unit (₹300 below normal price). Should you accept?
Analysis: Contribution Margin at ₹1,200 = ₹1,200 - ₹970 = ₹230 per unit
Total contribution from order = ₹230 × 500 = ₹1,15,000
Decision: If factory has spare capacity, accept the order! The ₹230 per unit still contributes towards fixed costs and profit. Fixed costs are already covered by regular production, so any positive contribution margin adds to profit.
Scenario 2: Product Mix Optimization
Factory makes three products with limited machine capacity:
| Product | Sale Price | Variable Cost | CM per Unit | Machine Hours | CM per Hour |
|---|---|---|---|---|---|
| Product A | ₹2,000 | ₹1,400 | ₹600 | 3 hours | ₹200/hour |
| Product B | ₹1,500 | ₹1,000 | ₹500 | 2 hours | ₹250/hour |
| Product C | ₹3,500 | ₹2,700 | ₹800 | 4 hours | ₹200/hour |
Decision: Product B has the highest contribution margin per machine hour (₹250), so prioritize it when machine capacity is limited, even though Product C has highest absolute contribution margin per unit.
Contribution Margin for Make vs Buy Decisions
When deciding whether to make a component in-house or buy from supplier, consider:
- If buying frees up capacity that can produce products with higher contribution margin per hour, buy the component
- If factory has idle capacity, making in-house adds to contribution margin even if slightly costlier than buying
Common Mistakes
- Confusing Gross Margin with Contribution Margin: Gross margin includes some fixed costs (like depreciation), contribution margin includes only variable costs
- Ignoring Capacity Constraints: High contribution margin product is only valuable if you have capacity to make it
- Not Tracking Actual Variable Costs: Assuming material costs without accounting for wastage and rejections
- Accepting Low CM Orders When at Full Capacity: Displacing high CM products with low CM orders reduces overall profitability
How Manufacturing ERP Tracks Contribution Margin
Modern ERP systems like Karygar track actual variable costs per product by integrating material consumption, labor hours, and power consumption data. Real-time contribution margin reports help identify most profitable products, optimize product mix, and make informed pricing decisions. Product-wise profitability dashboards show which products are contributing most to covering fixed costs.
See Contribution Margin in Action
Don't just read about Contribution Margin. See how Karygar automates this process to reduce manual work and errors on your factory floor.