The Contribution Margin abbreviated as CM is the contribution of each unit sold to the companies profit calculated as selling price per unit minus the variable cost per unit. These variable costs for a unit sold could include the cost of raw materials, fuel costs and the labor expenses for each unit. A business may have multiple product lines, and the CM is calculated for each of the products separately.

Contribution Margin of a company

Companies are selling either products or services, and businesses always aim to maximize the profit which they make. Hence it is important for the business to find out the profit which it is making for the product or services which it is selling. Typically the expenses of every business can be classified into the fixed expenses of the business, which it will incur even if there are no sales and the variable expenses. The variable expenses will vary depending on the number of units that are sold. Knowing the exact value of these fixed and variable expenses will help the companies control these expenses and profit better.

How to calculate contribution margin

Contribution Margin Formula

Contribution Margin = P – V

where P is the sales price of the product being sold and V is the variable expenses for the specific product, and the margin is calculated in dollar terms. In an alternate formula, the contribution margin ratio may also be calculated in percentage terms or a fraction of the sales price.

How to calculate contribution margin ratio

Unit contribution margin/Price = ( P – V) /P = Total contribution margin / Total revenues

The amount available after deducting the variable costs will help to offset the fixed costs of the business, and also contributes to the profit. The contribution margin determines the slope of the profit line of the business, how many units must be sold to make a profit.

What is a Good Contribution Margin? If a contribution margin percent or contribution margin ratio is close to 100% it is the better. The higher the contribution margin ratio is, the more money is available to cover the business’s overhead expenses or fixed costs.

Explanation

A business will usually pay all its expenses and make a profit from the income it receives from sales. Some of the business expenses are directly proportional to the number of units of products or services which are being sold. The sales revenues also help cover the fixed expenses of the business like the cost of land and machinery. The contribution margin is the amount in which the sale of each unit, contributes to the company profit and also helps the company pay for the fixed expenses for running the business.

Now, we have a practical question:

How is the contribution margin ratio useful in planning business operations?

The contribution margin is used extensively in management accounting, to determine the break-even point for the business. Companies will periodically analyze the cost of each unit, the volume of units and the profit it is making, for calculating the net income. This information is also used for fixing the targets for the sales team, determine the structure of the bonuses or commissions for the sales team. The margin can be used to determine the prices for the services or products sold, based on the market conditions like demand for the product.

The business can make decisions on whether it wishes to retain a product line or remove it based on its contribution margin. If a product line has a positive contribution margin it is retained, even if there is a loss after considering fixed costs, since the product line helps to offset the fixed costs. On the other hand, most businesses will be forced to close a production line, which has a negative contribution margin for a longer period of time, since it adding to the business losses, and is not sustainable in the long term.

The analysis of the contribution margin provides details of the leverage the company has since it is selling goods or services. It indicates the relation between the increase in sales of the company and the growth in the profit of the business. For management accounting purposes, the income statement is reformatted to group the variable costs and fixed costs separately and this statement is called the statement for contribution income. This statement will provide details of the contribution margin of each product or service sold. The contribution margin differs from the gross margin, which is calculated using accounting standards since the contribution margin is calculated after analyzing the nature of the expenses.

How to calculate the break-even point using the contribution margin:

Break-even point= Fixed expenses – Contribution margin per product

Other applications

In many countries, the tax authorities are also checking the contribution margin of business while investigating whether the business is paying the taxes which are due. Companies that have a higher ratio for contribution margin compared to other companies in the same industry sector are often shortlisted for tax investigations, to find the reason why the company is making more profit. Also, companies that have a monopoly or near-monopoly in their sector, often have a high contribution margin, since there is little or no competition. Hence the government may use the competition law on these companies.

Services and products

It is usually observed that manufacturing companies have a high fixed cost since the company has to invest large amounts in land, construction, machinery and other equipment. Hence they will price the products which they are manufacturing at a price so they have a high contribution margin. This margin is then used to cover the fixed expenses. On the other hand, the companies selling services, usually do not have to invest a large amount in the machinery, property. Since the competition for service providers is high, these companies have a lower contribution margin, though it may vary depending on the specific service being provided.

Conclusion

The Contribution Margin is an important parameter for any business since it helps the business decision on whether it is making a profit on every unit which is sold. While the overall profit depends on both the fixed and variable expenses, the contribution margin determines whether it is viable for the business to make and sell the product. If the contribution margin is low, the company may try to reduce the expenses for the product, or increase the price of the product.The parameter is also important for setting the sales target for the business to break even or make a profit.

Comparing discretionary and non-discretionary accounts

People invest their money in stocks, bonds, forex, and other securities to maximize their investment returns. Though the effort and time required to make money from investments is less than the time required to make money providing a service or doing a job, the investor still has to spend some time to manage the investment, choosing the right investment option to maximize the returns. For most securities, the investor has to use a broker’s services for trading since the broker will place orders or sell on behalf of the investor. The brokers offer discretionary and non-discretion investor accounts. The differences between these accounts are discussed for investors who wish to compare Discretionary vs. non-discretionary accounts before deciding.

Discretionary Account

An investment account in which the broker is authorized to purchase and sell securities without explicitly taking the client’s permission for every transaction is called discretionary. The investor, also called the client, should sign a discretionary disclosure or statement, in which the investor gives the broker permission to buy and sell securities. The discretionary account may also be called a managed account. The brokerages often specify that the client should invest a minimum amount, typically $100,000, to open a discretionary account. There are different types of accounts available, depending on the initial investment amount. The investor also has to pay fees for the assets which are managed by the brokerage.

Non-discretionary account

A non-discretionary account is an account where the client always decides whether or not to conduct a trade. A non-discretionary investment account is an investment account where the brokerage will only purchase and sell securities based on the investor’s orders. Though the brokerage may provide information, advice, and tips to the investor, the investor is ultimately responsible for deciding whether he wishes to purchase or sell the security. The brokerage is mainly responsible for getting the best price for the investor when purchasing or selling securities. The minimum amount of investment for the non-discretionary account is also usually lower.

Understanding Discretionary Account

Usually, for a discretionary account, the terms of the account are specified at the time of opening the account based on investment goals and investor risk tolerance. The brokerage will review the investor’s requirements, and the agreement will incorporate these requirements and the permissions the broker requires for executing the trades. The client may specify the criteria for trading with the discretionary account. For example, the investor may specify that he should maintain a specified ratio of stocks to bonds based on his risk appetite.

However, the broker may be free to invest in any bond or stock within the specified asset class. The investor may also specify that his money is only invested in reputed companies’ stock (blue-chip stocks) for safety. The broker managing the discretionary account has to ensure that he follows his client’s instructions and ensures that he complies with the constraints specified by the client. If the broker does not follow the client’s instructions and is making a loss, the client may initiate legal action against the broker. To open a discretionary account, the investor should find a brokerage offering the service.

In the last decade, investment management has been automated to a great extent, using algorithms to create a new category of discretionary accounts called robot-advisers. These accounts do not require human intervention for management and follow modern portfolio theory, yet the investment can be customized by the investor issuing instructions on choosing the securities. Since these accounts require very little human intervention, the robot-advised investment accounts may require low minimum balances in the account of $1-$5 and low or no fees.

Advantages and Disadvantages of Discretionary Accounts

The discretionary account’s major advantage is that they are very convenient since the broker does not have to waste time contacting the client before executing the trade. Most brokers handle a large number of clients and are well informed about the profitable investment opportunities available. So if the client authorizes the broker, they can invest quickly and make a profit. The broker can also get better pricing. In contrast, each investor may not have the time to research or get information on all the profitable investment opportunities available in the market, so that they may lose out on opportunities.

However, there are some risks involved in having discretionary accounts since a manager is spending time managing the trades and risks. The broker will usually charge a quarterly or annual fee for the service, affecting the overall returns for the investor. The fee will vary depending upon the amount invested. Also, there is no guarantee that the discretionary account will outperform the market despite paying higher fees. According to the study conducted by Asset risk consultants in 2015, it was observed that 50% of the discretionary accounts had underperformed the stock markets.

Advantages and Disadvantages of Non-Discretionary Accounts

Some investors prefer to manage their investments themselves, so in these cases, a non-discretionary account is better for them. The minimum investment and fees for this account are also lower. These accounts are ideal for investors who are already monitoring the financial markets and are well informed. However, a non-discretionary account’s main disadvantage is that the investor will have to spend his time researching the investment opportunities and managing his account. He may also not get good prices since he is acting alone and communicating with his broker.

Conclusion

Depending on their risk appetite, profile, and other factors, investors can choose between a discretionary or non-discretionary account. Usually, discretionary accounts are preferred by wealthy investors like professionals or celebrities who do not have the time and expertise to manage their investments themselves and are willing to pay the higher fees. Non-discretionary accounts are popular with smaller investors who have the time to manage their investment, research the investment options available before making a decision, and do not wish to pay the brokerage fees for managing their money.