Analyzing a company’s income statement yields many insights about the efficiency and effectiveness of operations, especially as it relates to total sales revenue and variable costs. The contribution margin is a metric that illustrates profitability before fixed expenses such as rent or salaries are factored into the equation. Below are additional details about the contribution margin, and how this important metric impacts business decision-making.
The contribution margin can be measured by subtracting total variable costs from total net sales. The contribution margin formula doesn’t factor in fixed costs, providing insight into how well a business manages costs as production volumes go up and down. The contribution margin can be used to evaluate variable expenses and their impact on profitability. A variable expense is one that increases as sales increase or decreases as sales decrease. Given that variable manufacturing costs can change as production levels fluctuate with the level of units that are produced, which can include expenses like direct labor costs, raw materials, and packaging. It is imperative that managers and business owners monitor the contribution margin as this is the foundation for break-even analysis used to determine the overall per unit cost and selling price for products.
We can also use this ratio to create a specialized income statement called a contribution margin income statement to determine how changes in the company’s sales volume impact the business’s net profits.
What Is The Contribution Margin Ratio?
The contribution margin ratio or CM ratio can be calculated using the total contribution margin and total net sales, or it can be calculated using the per unit basis.
The ratio of contribution margin is calculated by the following formula: total sales – total variable costs = Total contribution margin
When the company’s contribution margin is divided by net sales a percentage is generated. This percentage is the contribution margin ratio. This ratio is of vital importance because it can give management an indication of when production becomes less profitable, or when production pushes profit to the breakeven point.
Calculating the Contribution Margin Ratio
When calculating the contribution margin ratio, it helps to prepare an Excel workbook that has an income statement in it. This will help the preparer keep track of their work and create a report for presentation purposes. Linking the contribution margin ratio formula to the income statement will allow others to review the accuracy of the calculations. This is important for business decision-making purposes and modeling different scenarios relative to varying levels of production.
You can first calculate the total contribution margin, by subtracting variable expenses from net sales. Then you can calculate the per unit contribution margin and net sales, by determining the total number of units sold and then computing the per unit figures. When you divide the per unit contribution margin by the per unit net sales, you have arrived at the contribution margin ratio. This figure can be compared and tracked internally over time, to ascertain the efficiency and effectiveness of operations. The range of acceptable ratios is contingent on the industry and objectives of leadership.
What is the Difference between Contribution and Gross Margin?
The gross margin relates to profit, after cost of goods sold or cost of sales is deducted from net sales. This profit margin is divided by net sales to arrive at the gross margin. The contribution margin, however, measures net sales relative to variable costs, as mentioned above. The gross margin is an important metric, because it tells management how well it can control cost of goods sold or cost of sales. This is especially true when a company can compare its gross margin to competitors.
While the gross margin provides insight into the production, it does so by evaluating only COGS or COS. Evaluating variable overhead is critical for managing the business, and the contribution margin calculation is helpful in this regard. It provides management a different lens through which to identify gaps and opportunities for cost optimization. Variable costs can become high with low or high levels of production, which is why monitoring the contribution margin ratio will let management know the most profitable levels of production. Typically, high contribution margins are seen more often in capital-intensive industrial businesses that have expensive machinery and large production facilities, while low contribution margins show up more in service businesses that have more labor.
The contribution margin is more than an academic measure of profitability. Rather, it’s a valuable tool in discerning the efficiency and effectiveness of operations. Discontinuing particular products or even eliminating an entire product line with a low contribution margin can help improve a company’s total contribution margin. To improve a company’s contribution margin you will either need to reduce costs of variable expenses, such as raw materials or direct labor, or increase the sales price of your products and services. Managing this important margin well gives businesses a competitive edge over the competition with higher profits.