What do we mean by Contribution Margin and EBITDA?
The contribution margin is the margin that remains after the deduction of all the variable costs from a company’s net revenues over a given period of time. And net revenue is the amount we calculate after adjusting any sales returns or damages from total sales revenues. It is an important financial indicator that helps a company determine the viability of its operations. Similarly, EBITDA is also a financial measure of a company’s performance. And the full form of it is Earnings before interest, taxes, depreciation, and amortization. EBITDA focuses on operating profit. However, it does not include the impact of the non-operating figures, which are the result of the company’s long-term loans, tangible and intangible assets, tax liabilities, investment activity, etc.
The total costs in a company can be broadly classified into two categories – fixed costs and variable costs. The former portion of the total costs includes expenses that are constant with the level of production or service provided by the company. There is no connection between these costs and the operational efficiency of an organization. Such costs can be employee salaries, rentals of factory or office space, insurance premiums, depreciation, amortization, etc. On the other hand, the variable costs depend on the operation of an organization. They vary depending on the quantity and volume of production or the services offered by the company. In other words, these costs need to be incurred to produce every extra unit of production. So, they have a direct relation with the product quantity.
Examples of variable costs are packaging costs, raw material costs, and other inputs for production, sales commission, electricity bills, etc. The contribution margin is the money available after covering the variable share of the total costs for the calculation and provides information on the company’s operational efficiency. Or it is the excess of revenues over the company’s variable costs. And that is left for meeting the fixed costs and ultimately towards the company’s profits.
EBITDA also measures the operational efficiency of an organization. It excludes the following components from a company’s total cost:
Interest is the part of a company’s expenditure that it pays for loans it has borrowed from outside. Loans can be arranged against security or without any security. Banks or financial institutions generally lend only against collateral. Third parties, usually from known personal contacts, provide loans without collateral. The loan quantum varies from company to company, and hence, the financial cost is not taken into consideration to bring them at par for comparison purposes.
The government levies various taxes on the income or earnings of the organization. They are commonly referred to as corporate income taxes. They are a part of the expenses in an organization’s profit and loss statement. However, taxes are also kept aside to focus on operational efficiency like financial costs.
Depreciation expenses are non-cash in nature but are part of any company’s profit and loss account. Assets such as plant and machinery, equipment such as computers, etc., suffer wear and tear with regular usage and erosion in their value. Depreciation expense denotes that reduction in value. Hence, it is chargeable in the books of accounts of a company.
Any company’s intangible assets too erode in value over time, similar to tangible assets. Such assets can be goodwill, patents, trademarks, etc. Like depreciation, amortization is also a non-cash expenditure that flows as an expense to a company’s profit and loss account.
The formula for calculation of EBITDA is:
EBITDA = Net Income + Interest+ Taxes+ Depreciation + Amortization
EBITDA = EBIT or Operating Income + Depreciation + Amortization
What is the difference between Contribution Margin and EBITDA?
There seems to be a little difference between the contribution margin and EBITDA at a broad level. We deduct all the variable costs from the net revenue of an organization to calculate the contribution margin. Similarly, we calculate EBITDA by deducting all the expenditures from the net revenue, excluding interest charges, taxes, depreciation, and amortization charges. So, all non-cash and non-operational expenses are not part of the calculation in both cases. Of course, contribution margin goes one step ahead, and even the fixed costs are not taken into account for the calculation of contribution margin.
Fixed costs and variable costs
The contribution margin does not in any way include fixed costs and restricts itself to the variable costs. Actually, the contribution margin concept tries to derive the level of sales or break-even sales point where the expected revenue can even cover the organization’s fixed costs. And at that level, the organization neither earns any profit nor incurs any loss.
But as EBITDA is the net operational earnings, hence, all the costs remain and are form a part of expenses. Such costs are rentals and lease payments, salaries given to the workforce, premiums paid for insurance policies, and bills for various utilities such as electricity, gas, telephones, mobile services, etc.
Treatment of taxes
As the name implies, EBITDA does not include taxes. It gives the quantum of earnings before taking taxes into account. But there are some taxes that a company pays, which are a part of expenses. Their deduction is made from net revenue, even in the case of EBITDA. Such taxes may include property tax, payroll tax, sales tax, a few local city taxes, etc. Such taxes, if any, are a part of the Selling, Administrative, and General Expenses head (SG & A) in the profit and loss statement.
Basically, the taxes relating to corporate income, including those that arise from sales of assets and investment activity, remain out of this calculation. The contribution margin assumes that all taxes are not variable in nature and direct relation with the product is not possible. Therefore, it does not include any of the above taxes or even income taxes in the expenditure category. Taxes are not part of the calculation of the contribution margin.
Contribution margin and EBITDA are very useful for comparing two or more companies, industries, and their respective operating efficiencies. They can be a useful tool for determining whether an organization is able to service its debt. There is no need to worry about debt servicing if the interest burden is much lower than the contribution margin or EBITDA.
However, both parameters can also be misleading to a certain extent. The contribution margin totally ignores costs that are not variable in nature. It also ignores any cost that relates to the organization’s investments in its long-term productive assets, such as buildings, plants, machinery, etc. Similarly, EBITDA also ignores the high borrowing costs and the costs of such heavy capital expenditure. It does not include interest expenses, depreciation, and amortization charges. Hence, they might prove unreliable in the case of capital-intensive industries having a high quantum of fixed assets.
U.S. Generally Accepted Accounting Principles (US GAAP) do not recognize both the contribution margin and EBITDA. Therefore the calculation may vary from company to company, and thus the manipulation of results is possible to meet the needs of an individual company. Therefore, they are primarily beneficial internally or within the organization. Hence, one should take enough care while using both these parameters.
Frequently Asked Questions (FAQs)
No, both these are not the same. The contribution margin only considers the variable costs that change with changes in the level of production. While EBITDA includes fixed costs that remain constant with any production level.
Both the contribution margin and EBITDA help compare the operating efficiency of two or more companies.