Overview
The goal of most businesses is to make a profit. However, it often happens so that the company has great sales and the sales figure is impressive, but when you look down the Income Statement, you realize that most of this money earned went to cover various expenses. This is because it costs the company a significant amount of money to make the product, so the profit it earns does not cover all of the spendings that the business incurred.The contribution margin, in a general sense, is how much of the income you earned from selling a product or providing a service exceeds the variable costs of producing that product and generating that income. It is an accounting term that helps business owners and managers track the profitability of a product. It shows how much of a product’s income is available to cover fixed costs and contribute to the firm’s bottom line. Contribution differs from gross profit in that the goal of finding the contribution margin is to separate variable costs your business has incurred from fixed costs. This provides better information for internal purposes. The contribution margin is calculated and expressed in dollar amounts. However, this is not the only way to calculate it. You can also express it in a ratio form, which is known as the contribution margin ratio. This number tells you the portion of revenue that is left, if any, after the business has paid for all the variable.
Importance
The contribution margin is one of the important steps when analyzing how much the company needs to produce to at least cover its cost. It also measures how sales growth turns into profit growth. Thanks to the contribution margin, the management can see if the product or line brings enough profits to its owner or if it is going to be beneficial for the overall success to stop selling a particular good or service. The contribution margin ratio is a better indicator compared to a simple contribution margin when looking at different companies side by side or even different product options side by side because it allows comparing not the dollar value, which can vary from company to company, but the percentages. This gives a more correct and fair, in a way, analysis and comparison.
Example
So, is there a simple formula one can use to arrive at the contribution margin ratio? There are actually two formulas you can use to compute it. Let’s take a look at both.
- Per Unit RatioYour first option would be calculating this value on a per-unit basis. This is a good option if you would like to analyze different volume scenarios or use the per-unit value to compare different options. So, you need to know a contribution margin per unit first. This would be simply your sales price per unit fewer variable costs per unit. For instance, if you sell a cup of coffee for $4.25 and your variable costs are $1.10 per cup, then the contribution margin is $4.25 – $1.10 or $3.15. Next, you need to divide this number by the price per unit. So, you would get $3.15 / $4.25 = .74 or 74%. This means that 74% of your profit will go to pay for all the costs that you cannot avoid even if your production is paused for a short period of time and if there is something left over, it will be your net profit.
- Total RatioThe company might not always have per unit values or it simply needs an overall evaluation of the company. Thus, it would be reasonable to calculate the contribution margin ratio for the total sales and expenses. Let’s say you sold 400 cups of coffee over a specific period of time. So, using the info above, we can say that the total sales revenue for you was $1,700 and variable costs were $440. This means the total contribution margin is $1,260. If you divide this by $,700, then you will have a total contribution margin ratio of .74 or 74%. You should not be surprised that we received the same values for our ratio because it measures the same information only at different levels.
