The target of all the companies is to make sufficient profits so as to cover its fixed cost and make net profits. A company needs to spend money to make more money, however it needs to keep a track on how much in spends and whether it is earning sufficient amount so as cover its expenses. One important way to keep itself on track is by calculating the Contribution Margin. Contribution margin is the sales amount that remains after paying for the variable cost of the company so that the company can estimate the amount available to pay its fixed cost. Any amount which remains after deducting the fixed cost is called the net profit. The Contribution margin can help determine the break-even points, ways to cut down the cost or improve the pricing of the product and services that would ultimately improve the bottom line i.e., the net profit of the company.

WHAT IS CONTRIBUTION MARGIN?

The difference between the sales revenue and the variable cost of the company is referred as to the Contribution margin. The variable cost here is the cost that varies depending on the sales volume such as the Direct materials, per unit labor cost, sales commission, variable utilities etc. In short, Contribution margin is the amount of sales revenue contributed by a product or a service towards the fixed cost of the company like the rental expenses, interest and depreciation etc., that do not change with the change in sales volume. The Contribution margin can be shown as a dollar amount also known as the dollar contribution per unit or a ratio depending upon the formula used. We can use the Contribution margin for the business as a whole or a specific line of product or individual units of the product. The higher the contribution ratio the company can recover more of its fixed cost against the contribution margin and lower the ratio, the lesser the amount is available to cover fixed cost and generate net profit.

HOW TO CALCULATE CONTRIBUTION MARGIN?

The main formula to calculate the Contribution Margin is:

Contribution Margin = Sales Revenue – Variable Costs

However, is we want the Contribution margin per unit of product, the formula would be:

Contribution Margin Per Unit = Sales Price Per Unit – Variable Cost Per Unit

We can alternatively find the contribution margin in a reverse sequence by using fixed cost and net income as follows:

Contribution Margin = Fixed Costs + Net Income

Example: A manufacturer sells a bottle of body lotion for $15 and has a variable cost of $8 per unit of production of the body lotion bottle. This means that the contribution margin of the company on the sale of one unit of body lotion bottle is $7 ($15 – $8). This means the company has $7 per unit available to recover its fixed cost after which profit remains.

COMPONENTS OF THE FORMULAS

The first and foremost step in the calculation of the contribution margin is to take a traditional income statement and scrutinize it to categorize all the expenses into the fixed and variable cost. However, this process is not that straightforward because it may not always be clear as to what is the fixed and what is the variable cost of the company. For this we need to understand the components of the Contribution margin well, because a small mistake in the classification of expenses into fixed or variable can make a huge impact in the decision making process.

1 SALES REVENUE: It is the money that is bought into the company through the sale of product or rendering of services. In the top most item of the Income statement and is called by different names like sales, revenue or net sales.

2. VARIABLE COST: Variable cost are the direct and indirect cost related to product and services and varies with the volume of units produced or services rendered, the suppliers and the labor engaged in the production activities. In simple terms, more production means more variable cost and vice versa. A high proportion of variable cost relative to the fixed cost means that a company can continue with relatively lower contribution margin, whereas a low proportion of variable cost in relation to the fixed cost means that a company requires to generate a high contribution margin in order to continue its operations.

Some of the common examples of the Variable costs are given below:

• Direct Materials: Raw materials required directly for producing goods and are primary for production.
• Production supplies: Items necessary for maintaining the machines like oils and lubricants.
• Billable wages: Amount paid as per billed worked hours
• Per unit Labor: Amount paid per unit of production
• Variable utilities: Water and Electricity used to produce goods and services
• Commission: paid to salesperson
• Cost of shipping, freight and transportation of goods

Some people confuse the variable cost for cost of goods sold, however, the same is not true. We get gross profit when we subtract Cost of goods sold from the Revenue and gross profit is not same as the contribution margin. Cost of goods sold include both fixed and variable cost. For example, the cost of running the finance, accounting and IT groups are all fixed but the sales force may also be compensated with commissions which is considered as variable cost. Hence the operating expenses though generally treated as fixed may also cover variable cost.

Contribution margin unlike the Gross Margin only includes the variable cost.

3. FIXED COST: Fixed costs are those cost that stay unchanged regardless of the changes in the production flows or services produced. These costs are independent of the sales or the business operations and cannot be avoided by the company. Even if the production of the company shuts down for a few days or weeks, these expenses still need to be paid by the company. Fixed cost are used in the Break-Even Analysis to determine the price and level of production to ensure profitability.

 Some of the common examples of Fixed cost are given below:

• Interest Expense: Interest on borrowed funds that is required to be paid as per the Debt schedule and loan agreement.
• Depreciation and amortization expense: Cost of Fixed assets i.e. depreciation expense and amortization of intangibles recorded in the books of accounts written off over a period of time based on the accounting principles governing the company.
• Insurance: Insurance paid as per the Insurance policy and contract
• Property taxes: Tax charged by the government and paid by the company based on the assessed value of the property
• Rent, license or mortgages: Amount paid by the company for the use of the property
• Salaries: This amount is paid to the employees irrespective of the hours worked or units produced and is a fixed monthly charge.
• Fixed Utilities: Some cost is incurred in office administration and include- water, electricity and gas.

There are cost that contain a mix of fixed and variable elements and are also called as mixed cost or semi variable cost or semi fixed cost. For example, there may be a salesperson who is paid a fixed salary from the company but also earns a commission based on the number of units sold directly by him. Therefore, the fixed salary is covered under the fixed cost and the commission earned is covered under the variable cost. In such cases of semi variable cost component in the accounts of the company, the analyst has to be very careful in categorizing and breaking up the expenses into fixed and variable to calculate the contribution margin correctly.

4. NET INCOME: Net Income is the net profit made by the company after deducting all the cost whether fixed cost or variable cost from the revenue. It is basically sales revenue minus the cost of goods sold, business and administration expenses like marketing, rent, and advertising, interest cost and taxes and depreciation. Net income measures the profitability of the company by determining how much a company’s sales revenue exceeds its overall expenses.

BREAK-EVEN ANALYSIS

Contribution margin can help to assess the break-even point of a product to ensure that the business does not lose money on that product. For a zero profit or loss situation, it must be that the contribution margin is sufficient to cover the entire fixed costs of production. So mathematically speaking, Breakeven (BE) point is reached when

Contribution Margins = Fixed Costs

or

(Sales Price – Variable Cost) per unit * BE Quantity = Fixed Costs

or

BE quantity = Fixed Costs / (Sales Price – Variable Cost) per unit

CONTRIBUTION MARGIN RATIO

The contribution margin ratio shows what percentage of the company’s revenue is available to cover its fixed cost. The contribution margin ratio is the contribution margin divided by the sales revenue.

Contribution Margin Ratio = Contribution Margin i.e., (Sales revenue – Variable Costs)/ Sales revenue

The contribution margin ratio in the above example of Body lotion sale is 46.67% i.e.,(15-8)/15*100. This means that 46.67% of the products revenue is the contribution margin and is available for covering the fixed cost of the company and giving the net profit.

WHAT IS A GOOD CONTRIBUTION MARGIN?

The best contribution margin is 100%, and the closer the contribution margin of a product or service is to 100% the better it is. A high contribution margin means more amount is available with the company per unit of production to cover its fixed cost thereby leaving more money on hand with the company. However, what constitutes a good contribution margin varies from industry to industry and the type of the product or services, nature of variable cost etc. On the other hand, a product or service with negative contribution margin harms the business with every unit of production. They cost the company more to produce than they generate the revenue.

HOW COMPANIES USE CONTRIBUTION MARGIN?

The Contribution margin analysis helps the managers make several types of decisions from whether to add or subtract a product line from its business or to price a product or service or how the sales commission should be structured. Some of the common uses of the Contribution margin by the company are as follows:

1. Used to compare products to determine which to one to keep and which one to get rid of: A product or service with positive contribution margin is considered against the one with low or negative contribution margin. A product with negative contribution margin the company losses out and is harmed with every unit of production. In such cases of negative contribution margin the company should either drop the product or service line or increase the prices. Whereas on the other hand, a product or service with positive contribution margin helps company to cover its fixed cost and give net profit also and is worth keeping. Where a company especially those managing a portfolio of products and having limited resources at hand, should conduct a contribution margin analysis of products to decide which products or services to focus the resources on in order to expand the business and increase the profits.
2. It helps the managers evaluate the variable cost: It helps to determine the variable cost that does into the production of products or rendering of services and where the necessary cuts are required in the variable cost in case the contribution margin is negative. In case of exceptionally good contribution margin the managers may increase the variable cost only to improve the product quality or improve other product aspects.
3. Helps to price the products and services: It is used to price the products and services so that the company not only is able to recover the variable and fixed cost associated with the product or service but is also able to generate net profit which can be reinvested back into the business.
4. Helps to structure the sales commission and bonuses of sales person: It helps to decide and structure the sales commission to be paid to the sales person according to the salespeople’s efforts in contributing to the contribution margin.
5. Helps to determine a products or service’s break-even point: Break-even point is where the total fixed and variable cost match the total revenue. The break-even point in dollar terms for any given offering is calculated by subtracting fixed cost from the contribution margin. In unit terms, the break-even point is arrived by dividing the fixed cost by contribution margin of a single unit produced. A company can realize profit only by exceeding the break-even point. The break-even point may be exceeded either from additional sales revenue generated or increasing the sales price or selling additional units of the product.

HOW TO IMPROVE THE CONTRIBUTION MARGIN OF THE COMPANY?

The target of every company is to have products or services in its portfolio which provides a positive and high contribution margin as it ensures that its fixed business expenses will be well covered and net profit is available for growing business further. If a company has low or negative contribution margin, the managers can take one of the few actions listed below to improve its contribution margin, depending on what is feasible decision for the company.

1. Cutting down the variable cost of products or services with low contribution margin: The variable cost of low contribution margin may be reduced to increase the contribution margin per unit. The company may opt for low priced packaging of the products or to save electricity turn off the machinery overnight. It could also reduce the discount offered on the products or cut down on expensive laborers. The company should save on its variable cost without effecting the production process or the product overall quality which could impact the customer base in the long run.
2. Increasing the sales price or sales volume: If a product has low contribution margin but enjoys a loyal customer base who are ready to pay a premium price for the product, then the company can resort to increasing the sales price of the product. However, if the company knows that the customers will not pay any extra for the product above its existing price but the product have a consistent product market, then it can target on increasing the sales volume that could possibly cover the existing fixed cost of the company thereby generating net profit.
3. Improvement can be achieved through process costing: through this method the manufacturers track the cost of each step in an items production process. This detailed analysis can help the company managers to pinpoint the places where unnecessary cost can be cut down. However, process costing is a time consuming process and is best suited for companies that produce homogenous products in large volume.
4. Focusing resources on products with high contribution margin: Every company have limited resources at hand and the target of every company is to maximize profits for reinvestment and also for the shareholders. Thus, companies with multiple product line, should conduct in-depth analysis of the contribution margin, to determine which product or service give highest contribution and which product should be dropped off due to negative or low contribution.
5. Invest in new machinery that would increase the production in the given period of time: The company may decide to invest resources in additional machinery required to produce more products in the given period of time to increase the contribution of the product.

MISTAKES THAT MAY BE MADE IN CONTRIBUTION MARGIN ANALYSIS AND DECISIONS TAKEN THERFROM

The contribution margin is one of the profitability margins used by businesses, analyst and individuals to analyze the product or service performance in terms of how its contributes to cover a companies fixed and unavoidable cost and give profits as an end result. However, the contribution margin should not be the only metric relied upon before taking any major business or investment related decision.

The common mistakes one may make in contribution margin analysis are as follows:

1. Categorization of cost that do not neatly fall in the bucket of fixed or variable cost: There are some cost which are semi variable or semi fixed in nature and it is difficult to clearly classify them into either variable or fixed cost. For example: sometimes the salary cost of certain employees may be debatable since it includes both fixed salary component and variable commission based element, R&D expenses is considered in some cases a fixed and some variable. The contribution margin could be effected dramatically due to classification of expenses into fixed or variable, and can affect the major production related decisions of the company.
2. Sometimes managers assume that low contribution margin products or services should always be cut off: The contribution margin should never be used alone to take any major decision. A manager should also consider fixed cost allocation along with other metrics to determine whether to continue producing a product or cut it off completely. There may be a product which has contribution margin but which also requires low amount investment in sales or R&D support. These products may have high variable cost but relatively very low fixed cost and ultimately may give net profit higher than the product with high contribution margin. These products may fill up the product line and act as a barrier to entry for a competitor and hence should be considered to be kept instead of dropping them off solely on the basis of low contribution margin.

GROSS PROFIT MARGIN VS CONTRIBUTION MARGIN

Many a times people confuse between contribution margin and gross profit margin since both are measure of profitability, However, both the measures are quite different from each other.

Contribution margin removes the variable cost from the sales margin leaving only the amount of revenue available to cover the fixed expenses. Any revenue portion left after deducting fixed expenses from the contribution margin, may be the net profit available with the company.

On the other hand, the Gross profit margin subtracts the cost of goods sold from the sales revenue. Cost of goods sold include both fixed and variable cost and is the measure of overall profitability rather than analyzing the individual products performance.

EXAMPLE OF CONTRIBUTION MARGIN ANALYSIS AND COMPARISON OF PRODUCTS BASED ON CONTRIBUTION MARGIN

The following is the sales and product information used to show comparison of the contribution margin for the company as a whole, by region and by product.

Sales	East	West	Total
Product 1	$       1,40,000	$           80,000	$       2,20,000
Product 2	$           60,000	$       1,20,000	$       1,80,000
Total	$       2,00,000	$       2,00,000	$       4,00,000
Variable Manufacturing Costs
Product 1	$           25,000	$           14,000	$           39,000
Product 2	$             5,000	$           14,000	$           19,000
Total	$           30,000	$           28,000	$           58,000
Variable Selling Expenses
Product 1	$           60,400	$           26,000	$           86,400
Product 2	$           14,300	$           35,000	$           49,300
Total	$           74,700	$           61,000	$       1,35,700

The contribution margin for the company as a whole is calculated as follows:

Sales	$       4,00,000
Less: Variable Manufacturing Cost	$           58,000
Less: Variable Selling Expenses	$       1,35,700
Contribution Margin	$       2,06,300
Contribution Margin Ratio	52%

This shows that for every $1 of sales revenue, only $0.52 remains after variable costs to cover the fixed cost and give net profits. The contribution margin is $2,06,300 and the contribution margin is 52% {($400000-$206300)/400000*100}. If the fixed cost was $100,00, then the net profit would be $106,300.

Let’s now do the analysis of contribution margin product wise.

	Product 1	Product 2
Sales	$       2,20,000	$       1,80,000
Less: Variable Manufacturing Cost	$           39,000	$           19,000
Less: Variable Selling Expenses	$           86,400	$           49,300
Contribution Margin	$           94,600	$       1,11,700
Contribution Margin Ratio	43%	62%

We can see that the Contribution margin of Product 1 is lower than the Contribution margin of product 2. Irrespective of Sales revenue of product 1 being higher than product 2, the contribution margin and contribution margin ratio of product 1 is lower than product 2.

The managers may decide to focus more on sales of Product 2 or may look into ways to contain the variable cost of product 1.

Let’s now do the analysis of contribution margin area wise.

	East	West
Sales	$       2,00,000	$       2,00,000
Less: Variable Manufacturing Cost	$           30,000	$           28,000
Less: Variable Selling Expenses	$           74,700	$           61,000
Contribution Margin	$           95,300	$       1,11,000
Contribution Margin Ratio	48%	56%

The Contribution margin of West region is higher than the East region, irrespective of the sales revenue being equal for both the regions. The managers should look into ways to contain the cost in the east region to improve the contribution margin.

In a similar way, the company can use the contribution margin to analyze the contribution margin of different sales person to determine the sales commission to be paid, or customer wise to determine which type of customers to focus on.

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