This week in the live session we will look at something called the contribution margin. This is a widely used concept for those of you in accounting and finance. The contribution margin (P – MC) or (P – AVC), is also sometimes represented as percent contribution margin is (P-MC)/P or (P-AVC)/P where:
- P is the price charged for one unit of an item, and;
- MC is the marginal cost or AVC is the average variable cost measures the cost of making one item.
- Marginal cost and Average variable cost are not always the same, but for this equation either can be used. The choice of which to use usually is driven by what data is available.
Let’s focus on the heart of this equation (P-AVC). The equations show the spread between the price, P, at which we sell an item, and the MC or the AVC shows the cost of making one item. That spread is the net profit per unit. It represents a net gain from the sale of one more unit. Now, when economies of scale or economies of scope increase, both have the same effect, and cost decreases. The spread, the gain from selling each unit increases, and the marginal profit rate increases. But when there are decreases in economies of scale or scope, the spread between price and MC and AVC narrows. Net profits per unit fall.
The contribution margin shows how profits expand and contract as costs change. Both economies of scale and scope change costs, but they do so through different processes. Can you explain that difference? It is a tricky idea, but understanding the difference is one way to think about how to engineer new business opportunities.
Feeling challenged by the discussion? Just try the discussion preparation to help.