Contribution Margin

Definition of Contribution Margin:

The contribution margin represents the contribution of each product to the company’s total profits. It is the cost of the product minus the variable costs. It shows you the total amount of revenue available after subtracting variable costs to cover fixed expenses and provide profit to the company.

Characteristics of Contribution Margin: 

The features of this are listed below-

  1. It is used to measure the profit potential of a product.
  2. It indicates how much of the company’s profit comes from that product.
  3. It shows the portion of sales that helps to cover fixed costs.
  4. It is the foundation of break-even analysis.
  5. It can be used to determine the selling price of the product and profits expected from the sales. 

Applications: 

The contribution margin represents a company’s product profitability. The company needs to do this analysis as it helps them forecast their product’s future sales and profit percentage. The contribution margin is decisive because it represents how much money is available with the company to pay the fixed costs, such as rent and other utilities, that paid even when production or output is zero.

Formula: 

The contribution margin calculated by subtracting variables cost associated with the product from the total sales of the product.

Contribution Margin=Sales Revenue − Variable Costs

Or

Contribution Margin Ratio = (Sales Revenue – Variable Costs) / Sales Revenue

Pros:

  1. It helps company management to select a product from the various possible product that uses similar manufacturing resources.
  2. One of the most significant advantages is that it is straightforward to use.
  3. Another advantage is that contribution margin analysis is done by using the information that the company’s management already has, and hence there is no need to calculate these prices exclusively.
  4. Low margins indicate that economically nonviable products should be discontinued.
  5. Investors also keep a close eye on the contribution margin to assess a company’s high performing product value. Company shifting its focus from its star product or any new competitor product emergence may indicate a reduction in the company’s profits and, eventually, a reduction in its share price.

Cons:

  1. We assume that the selling price of the product is constant, which is not in many cases, such as when some discount is given to a particular buyer.
  2. We assume that cost is linear and can easily divide into fixed and variable expenses; however, some of the costs are quasi-variable, which do not fall entirely in any of these two categories.
  3. We assume that manufacturers produce and sell the same number of units.
  4. Multiple-product businesses are assumed to maintain the combination among their services and goods constant even as the purchase pricing changes.

Conclusion:  

We could conclude that the contribution margin is essential for each company to know its product profits. This also helps the company’s management to make an informed decision regarding which products bring the most profit to the company. The contribution margin says a lot about a company’s revenues, expenses and gains or losses hence it is significant.