In this article, you will learn:
- Contribution Margin Definition
- Contribution Margin Formula
- Contribution Margin Formula Components
- Contribution Margin Per Unit
- Contribution Margin Ratio
- How To Calculate Contribution Margin?
- Example of Contribution Margin
- Contribution Margin Calculator
- Use of Contribution Formula
- Disadvantages of Contribution Margin
As a business owner, you need to understand certain fundamental financial ratios to manage your business efficiently. These core financial ratios include accounts receivable turnover ratio, debts to assets ratio, gross margin ratio, etc.
However, there is one financial ratio that you often overlook. But it is quite useful to understand your business performance. This is the contribution margin ratio. It is important for you to understand the concept of contribution margin. This is because the contribution margin ratio indicates the extent to which your business can cover its fixed costs.
Furthermore, it also gives you an understanding of the amount of profit you can generate after covering your fixed cost. Such an analysis would help you to undertake better decisions regarding where and how to sell your products.
Therefore, we will try to understand what is contribution margin, the contribution margin ratio, and how to find contribution margin.
Contribution Margin Definition
Contribution Margin refers to the amount of money remaining to cover the fixed cost of your business. That is, it refers to the additional money that your business generates after deducting the variable costs of manufacturing your products.
Contribution margin calculation is one of the important methods to evaluate, manage, and plan your company’s profitability. Further, the contribution margin formula provides results that help you in taking short-term decisions.
Thus, the level of production along with the contribution margin are essential factors in developing your business. Now, it is essential to divide the cost of manufacturing your products between fixed and variable costs. This is to calculate the contribution margin.
Remember, you use contribution margin for internal analysis. Further, the contribution margin does not showcase the amount of profit that your business generates. Rather, it indicates the amount of money that your business can generate to meet its fixed expenses.
Thus, you need to make sure that the contribution margin covers your fixed cost and the target income you want to achieve.
Contribution Margin Example
Say, Erwin Bread Manufacturers produce whole wheat bread. One packet of whole wheat bread requires $2 worth of raw material. This may include wheat flour, yeast, etc. The electricity expenses of using ovens for baking a packet of bread turns out to be $1. Whereas the labor charge comes out to be $1.5.
Total Variable Cost
Thus, the total variable cost of producing 1 packet of whole wheat bread is as follows.
Total Variable Cost = Direct Material Cost + Direct Labor Cost + Overheads = $2 + $1.5 + $1 = $4.5
Thus, if Erwin bread manufacturers sell 1000 packets of bread, the total variable cost would be $4.5 x 1000 = $4,500.
Now, the fixed cost of manufacturing packets of bread is $10,000. This is the cost of ovens used to manufacture the bread. Thus, the total manufacturing cost for producing 1000 packets of bread comes out to be as follows.
Total Cost = Total Fixed Cost + Total Variable Cost = $4,500 + $10,000 = $14,500.
Accordingly, the per-unit cost of manufacturing a single packet of bread consisting of 10 pieces each would be as follows.
= $14,500/1000 packets = $14.50
Whereas, the cost of manufacturing one piece of bread $14.50/10 = $1.45.
If each packet of bread is sold for $16, the profit will be $16 – $14.50 = $1.50.
The contribution margin only takes into account variable cost. Thus, the contribution margin is as follows.
Sales – Total Variable Cost = $16 – $4.5 = $11.50
Remember, that the contribution margin remains unchanged on a per-unit basis. Whereas, your net profit may change with the change in the level of output.
Say, Erwin Bread Manufacturers sell 2000 packets of bread. Thus, the total cost comes out to be as follows.
= Fixed Cost + Variable Cost = $10,000 + $9,000 = $19,000
Per unit Total Cost = $19000/2000 = $9.5
Per Unit Profit = $16 – $9.5 = $6.5
As you can see, the net profit has increased from $1.50 to $6.50 when the packets sold increased from 1000 to 2000. However, the contribution margin for selling 2000 packets of whole wheat bread would be as follows.
($16 x 2000) – $9,000 = $32,000 – $9,000 = $23,000/2000 = $11.50
As you can see, the contribution margin per-unit remains the same. Even if the number of packets sold increased.
Contribution Margin Formula
As mentioned above, the contribution margin is nothing but the sales revenue minus total variable costs. The contribution margin formula is practical and simple. Thus, the following structure of the contribution margin income statement will help you to understand the contribution margin formula.
|Less: Variable Costs|
|Less: Fixed Costs|
|Operating Income or Loss|
Thus, Contribution Margin = Sales Revenue – Variable Cost
Contribution Margin = Fixed Cost + Net Income
Contribution margin is used to plan the overall cost and selling price for your products. It helps you in separating your fixed cost from variable cost. Further, it also helps in determining profit generated through selling your products.
This means the higher the contribution, the more is the increase in profit or reduction of loss. In other words, your contribution margin increases with the sale of each of your products.
Furthermore, an increase in the contribution margin increases the amount of profit as well. This is because your fixed costs remain the same.
So, you should produce those goods that generate a high contribution margin. As a result, a high contribution margin would help you in covering the fixed costs of your business.
Contribution Margin Formula Components
The following are the components of the Contribution Margin:
Variable Costs depend on the amount of production that your business generates. Accordingly, these costs increase with the increase in the level of your production and vice-versa.
Furthermore, the variable costs can be either direct or indirect. Direct Costs are the costs that can be directly identified or allocated to your products. For instance, direct material cost and direct labor cost are the costs that can be directly allocated with producing your goods.
The Indirect Costs are the costs that cannot be directly linked to the production. However, such costs are necessary for your business to operate. Indirect materials and indirect labor costs that cannot be directly allocated to your products are examples of indirect costs. Furthermore, per unit variable costs remain constant for a given level of production.
Fixed costs are the costs that do not change with the change in the level of output. In other words, fixed costs are not dependent on your business’s productivity. These costs remain fixed in the short-term.
That is, fixed costs remain unaffected even if there is no production during a particular period. Rent, depreciation, and interest are examples of fixed costs. Fixed costs are used in the break even analysis to determine the price and the level of production.
The fixed costs can decrease on a per-unit basis.
Sales revenue refers to the total income your business generates as a result of selling goods or services. It is often referred to as the top line of your business. Furthermore, sales revenue can be categorized into gross and net sales revenue.
The gross sales revenue refers to the total amount your business realizes from the sale of goods or services. That is it does not include any deductions like sales return and allowances.
On the other hand, net sales revenue refers to the total receipts from the sale of goods and services after deducting sales return and allowances.
Operating Profit or Loss
Operating profit refers to the profit your business generates from its core business operations. It does not include profit earned from additional sources like investments
Contribution Margin Per Unit
Contribution Margin Per Unit is the profit that remains on selling the single unit of your product. That is, the difference between per unit selling price and the per unit variable cost of your product.
In other words, contribution margin per unit is the amount of money that each unit of your product generates to pay for the fixed cost. Accordingly, the contribution margin per unit formula is calculated by deducting the per unit variable cost of your product from its per unit selling price.
Contribution Margin Per Unit = Per Unit Selling Price – Per Unit Variable Cost
Now, let’s try to understand the contribution margin per unit with the help of an example.
Contribution Per Unit Example
Say, your business manufactures 100 units of umbrellas incurring a total variable cost of $500. You plan to sell each unit of an umbrella at a price of $20. Accordingly, the Contribution Margin Per Unit of Umbrella would be as follows.
Contribution Margin Per Unit of Umbrella = Per Unit Selling Price of Umbrella – Per Unit Variable Cost of Umbrella
Per Unit Selling Price of Umbrella = $20
Per Unit Variable Cost of Umbrella = Total Variable Costs/Number of Units Sold = $500/100 units = $5
Contribution Margin Per Unit of Umbrella = $20 – $5 = $15
This means that $15 is the remaining profit that you can use to cover the fixed cost of manufacturing umbrellas. Also, you can use the contribution per unit formula to determine the selling price of each umbrella.
Say, you determine that the per unit variable cost of manufacturing 1000 units of umbrellas is $5. And the total fixed cost is $20,000. Therefore, the per-unit fixed cost will be = $20,000/1000 = $20
Now, the selling price per unit of an umbrella was $20. Therefore, the contribution margin per unit will = be = $20 – $5 = $15.
As you can see, the contribution margin per unit of output is not sufficient to cover the fixed cost associated with manufacturing an umbrella. This means you will have to increase your selling price to at least $25 to cover both fixed and variable costs.
Now, this situation can change when your level of production increases. As mentioned above, the per unit variable cost decreases with the increase in the level of production.
However, fixed costs remain the same. To understand this scenario let’s consider the above example.
Say, your business increases the level of production to 2000 units. Therefore, the variable cost per unit might decrease to $2 per unit. Whereas the fixed cost may remain the same at $20,000. Therefore, the contribution margin will be = $20 – $2 = $18.
This means that you can reduce your selling price to $12 and still cover your fixed and variable costs.
Contribution Margin Ratio
The contribution margin ratio refers to the difference between your sales and variable expenses expressed as a percentage. That is, this ratio calculates the percentage of the contribution margin compared to your company’s net sales.
The contribution margin ratio is also known as the profit volume ratio. It is one of the important financial ratios of your business. This is because it indicates the rate of profitability of your business.
Thus, the contribution margin ratio expresses the relationship between the change in your sales volume and profit. So, it is an important financial ratio to examine the effectiveness of your business operations.
Furthermore, a higher contribution margin ratio means higher profits. Provided the fixed costs of your business do not increase.
Also, you can use the contribution margin ratio to calculate the desired income your business intends to generate. Thus, the following is the formula for the contribution margin ratio.
Contribution Margin Ratio = Contribution Margin/Net Sales = (Sales – Variable Costs)/Net Sales
Therefore, it is not advised to continue selling your product if your contribution margin ratio is too low or negative. This is because it would be quite challenging for your business to earn profits over the long-term.
Contribution Margin Ratio Example
Dobson Books Company sells textbook sets to primary and high schools. In the past year, he sold $200,000 worth of textbook sets that had a total variable cost of $80,000. However, the fixed expenses contributed to $150,000. Thus, Dobson Books Company suffered a loss of $30,000 during the previous year.
|Less: Variable Costs $80,000|
|Contribution Margin $120,000|
|Less: Fixed Costs $150,000|
|Operating Loss $30,000|
Accordingly, the contribution margin ratio for Dobson Books Company is as follows.
Contribution Margin Ratio = Contribution Margin/Sales = $120,000/$200,000 = 0.60 or 60%.
This means Dobson books company would either have to reduce its fixed expenses by $30,000. Or increase its sales by $50,000.
How to Calculate Contribution Margin?
As mentioned above, contribution margin refers to the difference between sales revenue and variable costs of producing goods or services. This resulting margin indicates the amount of money available with your business to pay for its fixed expenses and earn profit.
Thus, the concept of contribution margin is used to determine the minimum price at which you should sell your goods or services to cover its costs.
The following are the steps to calculate the contribution margin for your business. And to understand each of the steps, let’s consider the above-mentioned Dobson example.
Determine Net Sales
The first step to calculate the contribution margin is to determine the net sales of your business. Net sales refer to the total revenue your business generates as a result of selling its goods or services. This is after deducting sales return and allowances.
Thus, to arrive at the net sales of your business, you need to use the following formula.
Net Sales = Gross Sales – Sales Return – Discount
Accordingly, the net sales of Dobson Books Company during the previous year was $200,000.
Calculate Total Variable Cost
The next step is to determine the variable costs associated with producing goods or services. Variable costs are nothing but the costs that vary with the change in the level of output. These include direct material costs, direct labor costs, transportation costs, and commissions linked with selling your products.
In the Dobson Books Company example, the total variable costs of selling $200,000 worth of books were $80,000. Remember, the per-unit variable cost of producing a single unit of your product in a particular production schedule remains constant.
Determine Contribution Margin
Once you have calculated the total variable cost, the next step is to calculate the contribution margin. The contribution margin is the difference between total sales revenue and the variable cost of producing a given level of output.
You need to calculate the contribution margin to understand whether your business can cover its fixed cost. Also, it is important to calculate the contribution margin to know the price at which you need to sell your goods and services to earn profits.
In the Dobson Books Company example, the contribution margin for selling $200,000 worth of books was $120,000. This was calculated using the following formula.
Contribution Margin = Total Sales Revenue – Total Variable Cost
Calculate Contribution Margin Ratio
The last step is to calculate the contribution margin ratio. This is because the contribution margin ratio lets you know the proportion of profit that your business generates at a given level of output.
Furthermore, this ratio is also useful in determining the pricing of your products and the impact on profits due to change in sales. Accordingly, in the Dobson Books Company example, the contribution margin ratio was as follows.
Contribution Margin Ratio = Contribution Margin/Sales = 60%.
Contribution Margin Calculator
The Contribution Margin Calculator is an online tool that allows you to calculate contribution margin. You can use the contribution margin calculator using either actual units sold or the projected units to be sold.
Thus, it will help you to evaluate your past performance and forecast your future profitability. Accordingly, you need to fill in the actual units of goods sold for a particular period in the past. Provided you want to evaluate your company’s performance. However, you need to fill in the forecasted units of goods to be sold in a specific future period. This is if you need to evaluate your company’s future performance.
How to Use a Contribution Margin Calculator?
You need to fill in the following inputs to calculate the contribution margin using this calculator.
- Per unit selling price
- Variable cost per unit
- Variable overhead expenses per unit
- Actual or forecasted units of goods sold
The following are the results that are generated using the contribution margin calculator.
- Total contribution margin (actual or forecasted)
- Contribution margin per unit (actual or forecasted)
- The contribution margin ratio (actual or forecasted)
- Total Sales Revenue (actual or forecasted)
- Variable cost per unit (actual or forecasted)
- Total variable cost (actual or forecasted)
Use of Contribution Formula
It is one of the important concepts of breakeven analysis. This is because the breakeven point indicates whether your company can cover its fixed cost without any additional funding from outside financiers.
Further, it is impossible for you to determine the number of units that you must sell to cover all your costs or generate profit.
Thus, contribution margin helps you to take certain important decisions as a business owner. These decisions may pertain to:
- pricing a product
- adding or removing an item from a given mix of products
- profit planning
- reviewing variations in the cost structure of your company
- analyzing variable costs and volume of operations
- determining the breakeven point and the target income
- forecasting estimated units of goods to be sold to breakeven or earn a target income
- calculating degree of operating leverage
- sensitivity analysis
Disadvantages of Contribution Margin
The following are the disadvantages of the contribution margin analysis.
- It is based on the assumption that a given level of output can be sold at the same price
- The contribution margin also assumes that the average variable cost remains the same at each level of output
- It also presumes that profits are dependent on the level of output only. That is, it ignores factors like technological changes, improved management, etc
- The contribution margin overlooks the selling costs and only considers the production costs
- It considers accounting data and hence does not take into account certain estimates
- The contribution margin also neglects the concept of price elasticity of demand