The contribution margin is the amount of sale which remains after deducting variable cost. It can be present in dollar amount or the percentage of sale. It is the amount which remains after deducting the cost of goods sold. Company will use it to settle the fixed cost, so the higher is the better.
Contribution margin usually calculates for:
- Total contribution: it is the contribution margin of the whole company. It can tell the amount which we will use to pay total fixed costs and remain as the profit for company.
- By Branch or manufacturing: the management may want to compare the contribution across multiple branches in order to access individual performance. It is very important for management to set the strategic decision.
- By Product line: Each product will generate different contribution margin, so management has to aware of that and set a strategy. They are highly likely to increase sale and production of high contribution margin product. On the other hand, they may decrease or stop the production of low contribution margin product.
- By individual product: contribution per unit also be calculated in order to help management to predict the company profit base on the sale quantities.
Contribution Margin Formula
Contribution margin = Sale – Variable Cost
= 100 – 40 = $ 60
Contribution margin ratio = (Sale – Variable Cost ) / Sale
= $ 60 / $ 100 = 60%
What are the Advantages of contribution analysis?
|Advantages of Contribution Analysis|
|Calculate the breakeven point||The contribution will help us to calculate the breakeven point, the level of the sale in which the company makes zero profit. The management wants to know the sales target which the company needs to make to cover the fixed cost. So we can get this figure by dividing the fixed cost with a contribution per unit.|
|Calculate the operating leverage||The contribution will tell the relationship between sale and profit. The increase in sales will increase profit, but the contribution will tell us how much or how many percentages it will increase. For example, we want to make $ 1 million, we can calculate the target contribution and then the target sale. So the management can set the target for the sales team easily.|
What are the Limitations of Contribution Margin?
|Limitation of Contribution Margin|
|Variable Cost not fixed per unit||This method assumes the variable cost will be fixed per unit and it will change base on the production level. If it cost $ 1 to produce one unit, it will cost $ 10,000 to produce 10,000 units. However, in real life, the variable cost will change at some level of production. Direct labor will increase when reach a maximum level and workers are required to work overtime with higher rate. For the material, we may be able to enjoy the bulk discount if we place a large order.|
|Fixed Cost not fixed||We assume the fixed cost will stay the same regardless of the production level. But it will not make the case when we reach a certain production quantities. The rental expense will not remain the same forever, as we produce more, we will need more space/warehouse. At some point, we will require to rent additional space which will increase the rental expense. For machinery, it also has the limitation, and we may require to increase the number of machinery in order to increase production.|