CONTRIBUTION MARGIN: HOW TO GET IT, EXAMPLES, ADVANTAGES AND DISADVANTAGES - DUDAS - 2025

The contribution margin is the ability of a company to cover its variable costs with sales. Therefore, it is the sales revenue minus the total variable cost incurred on the products. The contribution amount will serve to cover the total fixed cost and the rest will be the profit obtained by the business.

The calculation of the contribution margin is of great importance for any business. Not only does it help the company to evaluate its profitability, but it also helps to know the margins that the different product lines have.

By determining the contribution margin of different assets, a company can find out which product provides the highest margin and which product line performs the least.

The contribution margin is very useful for organizations. By using its formula, the company can set its pricing policies.

According to the analysis, the company can frame strategies and take the necessary actions. By collecting the data, the company will be able to increase sales of products that produce higher margins.

How is the contribution margin calculated?

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The contribution margin can be calculated using the following formula:

Contribution margin = (Sales revenue - Variable costs) / Sales revenue.

This formula calculates the contribution margin for all units sold. This margin can also be calculated in a very different way than other types of margins. With the help of the following formula, it can be calculated per unit:

Unit contribution margin = (Unit price - Unit variable costs) / Unit price.

In this case, it can also refer to the unit measure of a product's gross operating margin, because it is simply calculated as the product's price minus its variable costs.

Variable and fixed costs

When calculating the contribution margin, it must be determined which costs are considered variable and which are considered fixed. Variable costs refer to any expense that increases or decreases based on the amount of products produced or services provided.

For example, in a business that manufactures shirts, the cost of direct materials and labor will increase relative to the number of shirts produced.

If in the same business, the sales representatives earn a commission from the sale of these shirts, then this commission should also be considered a variable cost.

Variable costs do not include fixed costs such as office rental, insurance, equipment rental, and employee salaries that do not increase or decrease relative to production and sales.

Contribution margin indicator

The contribution margin can also be expressed as a percentage, called the contribution margin indicator, by expressing the number as a percentage of total income.

Contribution margin indicator = ((Sales revenue - Variable costs) / Sales revenue) x 100.

Examples

Example 1

Suppose the company HSC Ltd. sells a product for $ 200. The unit variable cost of the product is $ 80. This unit variable cost includes direct expenses for materials, labor, and variable overhead. The fixed indirect cost is $ 20. It is requested to calculate the contribution margin.

In this example, the fixed overhead is given separately. This is because it will not be included in the contribution margin calculation as it is not part of the formula. It then has:

Contribution margin = Sales income - Variable expenses = $ 200 - $ 80 = $ 120. Therefore, the unit contribution margin is $ 120.

Example 2

Goodey Company has net sales of $ 300,000, selling 50,000 units of its products. The unit variable cost is $ 2. It is required to know the unit contribution margin, the total contribution margin and the contribution indicator. It then has:

- The company has net sales of $ 300,000.

- The number of units sold was 50,000.

- The unit sale price would then be: ($ 300,000 / 50,000) = $ 6 per unit.

- The unit variable cost is $ 2.

- The unit contribution margin according to the formula would be: Unit sale price - Unit variable cost = $ 6 - $ 2 = $ 4 per unit.

- The total contribution margin would then be: $ 4 x 50,000 = $ 200,000.

- The contribution indicator would be: Contribution / Sales = $ 200,000 / $ 300,000 = 66.67%.

Advantages and disadvantages of contribution margin

Easy to use

The contribution margin is simply calculated as sales minus variable costs. It can be converted to a measure in units only by dividing it by the number of units sold.

This unit of measure can be quite useful, as it tells the amount of profit that will be made for each unit sold after the company reaches breakeven.

The total contribution margin is also helpful. If the total margin is greater than the company's fixed expenses, it means that the company is profitable, but if it is less than the fixed expenses, the company is experiencing a loss.

Information already existing

It is done with information that has already been calculated for other purposes. All companies calculate their sales figures and cost information is also recorded. The only additional work that needs to be done is to classify costs as fixed or variable.

Know the breakeven point

The breakeven point represents the amount of revenue needed to cover all of the company's costs, fixed and variable, before starting to generate profits.

The contribution margin is an essential component within the breakeven equation: breakeven point = Total fixed costs / Total contribution margin.

Knowing exactly how much revenue to generate to cover business costs will help set goals for the growth and expansion of the business.

Unrealistic assumptions

The main disadvantage is that some unrealistic assumptions are required. First, assume that the sale price remains constant. This means that no discount can be offered for large orders.

Second, it assumes that costs are linear and can be clearly divided into fixed and variable components. This is often easier said than done.

Third, multi-product companies are assumed to keep their product mix constant, even as their selling price changes. Finally, it assumes that manufacturers produce and sell exactly the same number of units.

The degree to which these assumptions affect the use of margin varies from company to company. However, these shortcomings must be considered when interpreting the results.

References

1. Sanjay Bulaki Borad (2019). Contribution Margin. Efinance Management. Taken from: efinancemanagement.com.
2. Kris Merritt (2020). Why a Growing Business Should Never Overlook Contribution Margin. Accounting Department. Taken from: accountingdepartment.com.
3. John Freedman (2020). Advantages or Disadvantages of Contribution Margin Analysis. Small Business – Chron. Taken from: smallbusiness.chron.com.
4. Ready Ratios (2020). Contribution Margin. Taken from: readyratios.com.
5. Wall Street Mojo (2020). Contribution Margin. Taken from: wallstreetmojo.com.