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.
