3. Contribution margin technique in CVP analysis

Another method used in CVP analysis is contribution margin technique.

Let's start with the definition of contribution margin.

Contribution margin (contribution) is the difference between sales and variable costs (expenses). Contribution margin contributes toward fixed cost and profits. Contribution margin may be calculated in total or per unit.

The calculation of a contribution margin in total is as follows:

The calculation of a contribution margin per unit is similar to the contribution calculation in total, except that all amounts are divided by the number of units:

For example, assume the following data is available for Friends Company:

Contribution margin is calculated by using the earlier formula:

Contribution = Sales - Variable Costs = $75,000 - $45,000 = $30,000

Contribution is $30,000, which is the amount remaining after variable costs to contribute toward (cover) fixed costs and profits.

The contribution margin per unit can be determined as shown below:

This $2 per valve contributes toward (covers) fixed costs and profits.

3.1. Contribution margin ratio in CVP analysis

Contribution margin ratio is the contribution margin divided by the sales amount. It is the percent of sales dollars available to cover fixed costs. Once fixed costs are covered, the next dollar of sales results in a company's profits. Contribution margin ratio is expressed as a percent.

Based on the figures from the example of Friends Company, the contribution margin ratio will comprise:

The 40% calculated above means that fixed costs and profits represent 40% of total sales (because the contribution margin is fixed costs plus profits, or sales less variable costs).

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