What is the Contribution Margin?
Definition: Difference between total sales revenue of a company and variable cost is called contribution margin. Some time contribution margin used as a ratio. It is the sales amount which is used to pay off the fixed cost.
What is meant by a product’s contribution margin ratio
This ratio contribution margin depends on the fixed cost and variable cost. Fixed cost may be the production cost which remains the same on the increment of production level. Whereas variable cost increase with the increment of production level.
Contribution margin uses to calculate the efficiency of the company to produce the product and maintain the low level of variable cost.
Companies report margin to the public that’s why it is known as a managerial ratio.
Below formula work as a contribution margin calculator through which we can easily find the contribution margin by putting values in it.
How to calculate overall contribution margin ratio
The contribution margin formula can be calculated by subtracting the total variable cost from total revenue that is.
Contribution margin formula
Contribution margin= net sales – variable cost
Contribution Margin Formula Component
Two main component of contibution margin formula are net sales and variable cost.
Net sales: It is the total amount which company expects to receive for the total sales.
From the income statement, the revenue amount can easily found. In some statements, there is total sales mention as net sales whereas in some statement allowance and returns deduct from the total sales for calculating the net sales.
Variable cost: Variable cost considered as the expenses which increase by the increase of revenues or operations.
Raw materials are the example of the variable cost. For the production of more units more material need. SO with the increment of production materials cost decrease and vice versa.
Types of variable cost are:
- Shipping cost
- sale commission
- labour cost
- production supply utilities
Difference between variable and fixed cost
Difference between fixed and variable cost is their correlation with production. Variable cost is directly proportional to the production which increases with the increase of production.
whereas as a fixed cost not affected by the changing level of production e.g rent of the building which remains fixed have no concern with the production increment or decrement.
Contribution margin Calculation:
There are values of the company that the company has $1,000,000. this company has the following variable cost
Shipping cost= 100,000
Production supplies= $300,000
From the above values, we calculate the contribution margin of the company.
Contribution margin= 1,000,000- (100,000+50,000+400,000+300,000)
Contribution margin =(1,000,000 – 850,000)
Contribution margin = 150,000
Now subtract the fixed cost from the contribution margin in order to get the profit of company that is.
Property tax= $15,000
Total fixed cost is (45000+45,000+15,000)105,000. So the company get the profit of 45,000 dollar at the end of year which is get as
150,000 – 105,000= 45,000
From the above procedure you learn that how to calculate contribution margin.
Analysis and interpretation
What is contribution margin use for?
For the calculation of breakeven point of the business for the department contribution margin is helpful. From this, we can calculate that which product or operation is profitable for business and which is not. After that department decides to close the unprofitable operations.
For the income management purpose contribution margin is used. If the company has a target which company wants to achieve in next year then for that purpose it needs to use the CM formula for making product pricing model.
Analyst and management use CM formula to check the efficiency of the company to produce the profit. For measure, the forecasted margin of the company for next year CM is used.
Analyst and investor check the contribution margin ratio of the company to check the efficiency of the company that the company is profitable or not. If CM margin is high then the company is profitable and it is a good sign for the investors and analyst. If the CM margin is low then the company is in the loss.
Contribution Margin Per Unit
Contribution margin can be calculated by subtracting the net variable cost per unit from the total sales price per unit that is.
Contribution margin per unit= total sales – net variable cost per unit
To calculate the break-even point of production process contribution margin per unit ratio is use.
Contribution Margin Ratio
Contribution margin ratio can be calculated by divide the contribution margin per unit by sales price per unit that is
Contribution Margin Ratio= Contribution margin per unit/sales price per unit
In the break-even analysis managerial accountant use CM ratio to calculate the break-even point.
For more Financial Ratio Check:
Cash flow coverage ratio
Compound annual growth rate (CAGR)