Contribution margin helps in studying how revenue or sales affect profits or net income. It is expressed as a percentage, and we can calculate the contribution margin ratio by subtracting sales from variable expenses and dividing it by sales. Basically, it tells the marginal benefit of making or producing one more unit. In absolute terms, it represents the earnings available to pay for the fixed expenses.
We can calculate contribution margin in three forms – In total; Per unit and As a ratio. All three forms together help us understand how different factors – sales price, sales volume, variable costs, and fixed costs – connect to each other. Thus, they allow managers and management to make better decisions when it comes to sales and costs.
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Three Forms of Calculating Contribution
Lets’ understand the three forms in detail;
This measures the absolute amount of contribution margin that a company enjoys. The formula for Total contribution margin is Total sales Less Total variable costs. One can use this to determine overall profitability by comparing the total margin to fixed costs. Net income for a company will be the contribution margin Less fixed costs
One can also use the contribution margin to prepare a contribution margin income statement. This statement helps in understanding how sales will affect profitability and also cost behavior. Amounts, such as sales, variable costs, and contribution margin, change in proportion to each other. For instance, if sales increase by 10%, then contribution margin and variable costs would also rise by 10%. The fixed costs, however, remains the same.
The contribution margin income statement is different from the income statement. In the contribution margin income statement, we first subtract variable costs from sales and then fixed costs. In this, variable and fixed cost includes both manufacturing and selling costs. Following is a proforma of a contribution margin income statement –
|Less: Variable Cost||1,000|
|Less: Fixed Cost||500|
|Less: Provision for Income Tax||200|
Calculating per unit of contribution margin tells how sales of additional unit impact the net income. We can calculate it by subtracting the sales price per unit from the variable costs per unit. For example, a smartphone sells for $1000 and the variable cost of each unit is $600. In this case, the contribution margin per unit is $400, or we can say selling each unit increase the net income by $400. We can also say that any increase in the selling price won’t affect the variable cost, and thus would lead to more profits only.
As a ratio
When we calculate the contribution margin ratio, it tells the percentage of sales that would help to increase the net income. To calculate the contribution margin ratio, we divide the contribution margin by sales. The contribution margin or sales can either be total or per unit. The formula for contribution margin ratio is;
Total contribution margin / Total sales or Contribution margin per unit / Sales price per unit
Lets’ understand the concept with the help of a formula. Suppose a machine sells for $1000, while its variable cost is $500. The contribution margin, in this case, is 50%.
To understand how the sales will affect the net income, all we need to do is multiply the margin ratio by sales amount. In the above example, we can say that $1000 sale increases the net income by $400.
Let us understand all three forms of contribution margin with the help of a simple example. Company A has net sales of $300,000 after selling 50,000 units of its products. The variable cost per unit is $2.
In this example, the selling price per unit will be $6 ($300,000 / 50,000). So, the contribution margin per unit will be $4 (Selling price per unit – Variable cost per unit).
Now, Contribution would be $200,000 ($4 * 50,000), while the contribution margin ratio is 66.67% (Contribution / Sales).
Error to Look for When you Calculate Contribution Margin
One common mistake that many make while calculating the contribution margin is that they wrongly classify the fixed and variable costs. Thus, to avoid such error and accurately calculate the ratio, it is imperative to have a clear understanding of what the company classifies as a fixed or variable cost.
Sometimes, however, it gets difficult to classify certain items. For instance, a company buys software to boost production on a temporary basis. One can classify it either as a variable or fixed cost. Variable cost because it is directly related to the production, and fixed cost because it is a one-time investment.
It will be correct to put it in either head, but the company should give proper information. Also, it must ensure that the current treatment of the item is in-line with the previous treatment of the same item or the company should treat it the same way in the future as well.1,2