Contribution margin, explained simply
Gross margin deducts all costs of goods sold, fixed and variable. Contribution margin deducts only variable costs from every area, including freight and sales commissions, so it answers the incremental question: how much is kept from one more unit sold.
It supports pro forma adjustments such as closing a weak line, and shows how profit responds when volume rises or falls.
Variable cost and contribution by product line
IllustrativeAlder Creek Manufacturing, $ millions
Line Y generates 29% of revenue but only 19% of contribution.
Calculation
Worked example
| $ millions | Line X | Line Y | Total |
|---|---|---|---|
| Revenue | 30.0 | 12.0 | 42.0 |
| Variable costs | (19.5) | (9.6) | (29.1) |
| Contribution margin | 10.5 | 2.4 | 12.9 |
| Contribution margin % | 35% | 20% | 31% |
Alder Creek Manufacturing, Inc. is a fictional company. All figures are illustrative.
If shared fixed costs are allocated by revenue, Line Y may be loss-making. A buyer may plan to reprice or close it.
Gross margin and contribution margin compared
| Gross margin | Contribution margin | |
|---|---|---|
| Deducts | Cost of goods sold, fixed and variable | Variable costs only, from all areas |
| Best for | Overall pricing and production efficiency | Product, customer and pricing decisions |
Why it matters in a deal
It shows which parts of the business create value, supports pro forma adjustments and shows sensitivity of profit to volume.
Red flags
- Costs classified as fixed or variable without evidence
- Semi-variable costs, such as overtime or utilities, ignored
- Loss-making products or customers hidden in totals