The weighted average contribution margin of a company or business unit is the amount by which an incremental unit of net sales contributes to total profit.
For a single product business, the contribution margin is the difference between selling price and variable costs. If you buy widgets for $5 (variable cost) and sell them for $10 (unit sales), your unit contribution margin is $5 per unit. Taken as a percentage of sales (the contribution margin ratio), this would be 50%.
Further analysis to determine the breakeven point for the business would compare the contribution margin with fixed expenses. The difference is your total profit.
If you have multiple products in a business, you can weight your sales mix by sales volume to understand the aggregate impact on the business. This enables you to understand the impact of different products (which may be sold at a different selling price or gross margin) on the sales revenue of the company. This is critical if you are managing a multiple product company.
Using the weighted average contribution margin implies there won’t be changes in the sales mix percentage between products. If product A has a different margin than product B, changing the sales mix will affect the overall results.
Calculating Target Profit
In addition to calculating the break even point of the company, you can use the weighted average contribution margin to assess what total sales volume is needed to reach your target profit.
Supposed we have $10,000 of total fixed cost and want to generate $10,000 of operating income (net profit margin) for the overall business. In that case, our total contribution margin needs to be $20,000. We will need to generate enough sales to cover that level of contribution margin. If our weighted average contribution margin is 50%, we’re going to need $40,000 of total sales volume to make this work.
Cost Volume-Profit Analysis
This kind of modeling can be generalized into what is know as cost volume profit analysis, a method of exploring how the business will perform under different sales volume targets. You will use your assessment of weighted average contribution margin to calculate total profit for different scenarios.
CVP analysis generally assumes that fixed costs and total variable cost will not change as sales are removed from the equation. This is rarely the case in reality: adding or removing products and substantial sales volume from a business usually changes the underlying cost structure. This is a key source of synergies from a corporate merger.