What Is Contribution Margin? | Finance for Dummies

In accounting, contribution margin is the difference between a company’s total sales, revenue, and variable costs. You can use the contribution margin formula to determine how much of a company’s revenues will be contributing to the business’s net income and fixed costs, after deducting the variable costs. It can be presented as the amount for a single unit or product, the total amount of the company, and as a ratio or percentage of the net sales. You can also use the formula to calculate a business’s break-even point. This article is an overview of what is contribution margin, its entities, advantages, and disadvantages.

The Concept of Contribution Margin

Overall, the concept of a contribution margin (CM) relies on the difference between fixed costs and variable costs. The fixed costs are the costs in a business that remain the same while variable costs increase depending on the production levels. The management uses this equation to help improve their internal operations in the production process because it ascertains how your company can conveniently produce goods as well as keep its variable expenses low.

How to Calculate Contribution Margin

The contribution margin is calculated by subtracting your company’s total variable costs from your net sales. The contribution margin formula is the following:

Contribution Margin = Net Sales – Variable Costs

The net sales are the gross sales reduced by returns, customer discounts, allowances, and freight out. It is the net amount that your company should expect to get from the total sales. This figure is usually reported on your income statement.

On the other hand, variable costs are the expenses that increase as a company’s operations and revenues increase. For instance, if your company intends to produce more units, you will need more raw materials. Therefore, the cost of raw materials will increase with your level of production. Some examples of variable costs include labor costs, sales commissions, shipping costs, and production supplies. Generally, these costs are not reported on the income statement and you have to scan it to determine them.

Fixed costs mostly differ from variable costs because they do not change with the level of production. They are costs that your business has to incur whether it is producing or not. A good example of a fixed cost is rent. Regardless of how many units you intend to produce, the rent will still remain the same. If your margin is high, it means that you are able to sell your goods for more than the variable costs or your variable costs are very low. When the margin is low, this indicates that your products are not profitable.

Advantages and Disadvantages of Contribution Margin

Just like any accounting concept, knowing what is contribution margin is not enough. You also need to know its advantages and disadvantages. Management analyzes it to come up with decisions that ensure the organization is profitable. Some of the major advantages of a CM include its ease of use, its use of existing information, and the fact that management can use it to predict future sales. However, an attempt to find out what is contribution margin reveals that it has disadvantages such as ignoring elasticity and demand, the fact that it analyzes limited products, it has data limitations, has unrealistic assumptions, uses a constant price and cost, and it ignores the selling costs.

Advantages of Contribution Margin

Ease of use – One of the major advantages of a CM is its ease of use. It entails a simple calculation; deducting the variable costs from the net sales. Moreover, you can convert it to a unit-based measure by dividing it by the number of units sold. Managers can use it to determine the profit a company should expect up until the break-even point. The ease of calculation helps management to effectively determine if a product line will be profitable, and if not, what to do to achieve profitability.
Uses already existing information – A CM analysis is also advantageous because it relies on already existing information. Information that has been recorded on the income statement. The only additional thing that management requires in order to calculate the CM is scanning the income statement to determine the variable costs and the fixed costs respectively. Therefore, you can use it in your company to assess future profitability without incurring any extra cost in your operations.
Contingency analysis – In any business, it is very beneficial if you are able to have a forecast of the number of units you will sell in the future, be it after a month or six. The market for any product is very uncertain, and it would be helpful if you have a tool that carries out a contingency analysis. The CM, in its calculation has a margin of safety, which is the amount or percentage in dollars or units that you will sell beyond the break-even point. Having this information is very important, especially if your market segment is difficult to predict. It can help your company to determine if a specific product line will be profitable in the future.

Disadvantages of Contribution Margin

In identifying what is contribution margin, it is important to establish its weakness as an accounting tool. The weaknesses include:

It ignores elasticity of demand – A downside to using the CM analysis is that it ignores the factor of elasticity and demand. It ignores the fact that different prices may influence different levels of demand.
Only effective for short run analysis – Another disadvantage of the CM analysis is that it is only effective for short run analysis. If you intend to carry out a long run analysis to determine profitability, you will need to use other methods.
It assumes a constant price and cost – When calculating when your company will break even; you will need to use a constant price and cost. It assumes that every level of output will sell at the same price. This is delusive because prices constantly change. More over, it assumes that the regardless of the level of output, the costs remain the same. It is also impractical to assume that there is no limit as to what extent your company can produce a product.
Ignores the selling costs – The CM analysis only regards production costs ignoring the selling costs.
Limited products – Another disadvantage is that a CM analysis only regards a limited range of products. Since you cannot clump multiple products that your firm produces in a CM analysis, you can analyse just one product. This analysis also suffers from data limitations as it neglects certain aspects.
It indicates limitless profits – Yet another downside to using the CM analysis is that it assumes that profits are part of the output. It ignores the fact that a number of factors such as technology influence profits. CM assumes that profits increase limitlessly as the level of production increases.

Conclusion

To answer the question ‘what is contribution margin’, you have to first find the difference between the net sales and the variable cost. Management uses CM to measure a company’s ability to cover variable costs with profits. Generally, it is easy to use as it relies on already existing information. It helps to predict future earning until a company breaks even. However, it has unrealistic assumptions, and is mostly effective in constructing a short run analysis. Of course there is more on the CM analysis. If you have used it before, feel free to share your experience, thoughts, and questions.

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