The contribution margin can define by sale less variable cost, it can be present in amount or the percentage of the sale. It is the amount which remains after deducting the cost of goods sold, we 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 of the whole company, it can tell the amount which we will use to pay the fixed cost.
- By Branch or manufacturing: the management may want to compare the contribution across multiple branches in order to make strategic decisions.
- By Product line: each product will generate different contribution, so management has to aware of that and set a strategy which increases sale and production of high contribution product. And decrease or stop the production of low or zero contribution product.
- By individual product: contribution per unit also be calculated in order to help management to predict the increase of production which will impact the bottom line.
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 (link), 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 which the rate is higher. 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 quantity. The rental expense will not remain the same forever, as we produce more, we will need more space/warehouse. So 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 machinery temporarily in order to increase production.|