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 the sale. It is the amount that remains after deducting the cost of goods sold. Company will use it to settle the fixed cost, so the higher is the better.
Sale is the amount that seller receives after transferring the goods or service to the buyer. The company generates returns by selling the goods or services to the customers. It is the main purpose of the company is to generate sales and profit. The seller expects to receive the cash or other assets in exchange for the goods they provide. If they do not receive any cash or consideration, the transaction is considered as a donation rather than a sale.
It is the first line of income statement. The income statement starts with revenue and decreases by all type of expenses. The remaining balance will be the profit for the company. If the total expenses are more than the revenue, the company will make a loss in the period.
Variable cost is the cost that company spends to convert the raw material to finished goods. The variable cost per unit is not changed at all. It means each unit of goods requires the same level of variable cost. However, the total variable cost will change depending on the number of sales. The more we sell, the variable cost we need to spend.
Contribution margin is the amount left after we deduct the variable cost from revenue. It measures the more contribution company makes, the better it is. They will have a high chance of generating more profit while the fixed cost remains the same. If the contribution margin is negative, it means the company will make a loss even they increase the sale volume.
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 strategic decisions.
- By Product line: Each product will generate a different contribution margin, so management has to be aware of that and set a strategy. They are highly likely to increase sales and production of high contribution margin products. On the other hand, they may decrease or stop the production of low contribution margin products.
- By individual product: contribution per unit also be calculated in order to help management to predict the company profit based on the sale quantities.
Contribution Margin Formula
For example, ABC manufacture product X. Based on the company’s report, one unit of product require $ 40 of material and direct labor. The selling price is $ 100 per unit. The fixed cost allocate to each product based on the current month is $ 20 per unit. Please help to calculate the contribution margin per unit.
It is the contribution per unit, we have to use the selling price and variable cost per unit. We simply deduct the variable from selling price.
Contribution margin = Sale – Variable Cost
= 100 – 40 = $ 60
It means that for one unit of product sale, the company receives a contribution of $ 60 to settle for the other expense besides variable cost.
Contribution margin ratio is the percentage of contribution margin over the sale. With this percentage, we can calculate the contribution margin from the monthly or annual sale.
Contribution margin ratio = (Sale – Variable Cost ) / Sale
= $ 60 / $ 100 = 60%
It means that when company makes sales, only 60% of it will be contributed to the company profit. The 40% will be the cost of goods sold.
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 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 reaches a maximum level and workers are required to work overtime at 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 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 limitations, and we may require to increase the number of machinery in order to increase production.|
|Price Change||We assume that the selling price will remain the same even the sale quantity increase. It may be different as the company provides a discount to the bulk buyer.|
|Selling cost change||The contribution ignores the selling cost which is also changed in relation to the sale quantity. The calculation focuses only on the production cost.|
|New Technology||It also ignores the change of technology that will impact the whole production line.|