What is the Contribution Margin?
The contribution margin is basically the sales price less variable cost. The contribution margin in percentages is calculated by sales price less variable cost and then dividing by sales price. Mostly we use net sales to calculate the contribution. Variable costs are direct costs, including direct materials, direct labor, and other direct costs.
The total contribution margin is the accumulation of all contributors for a period of time without including total fixed costs and operating expenses.
The contribution is significant for management to control its performance as it is linked to the break-even point. And to measure how much the entity needs sales to cover the fixed cost and operating expenses.
In general, the company always has an annual budget for Net of Profit set by the board of directors. To make sure the company could hit this budget, we must know how much it could sell for the year, total contribution, cost of goods sold, fixed cost, operating expenses, and other expenses.
It could be because of production design, production process, cost of raw material, or other factors based on the investigation. The contribution margin also helps management analyze its company’s margin with competitors or the market as a whole. If the company has a low margin than its competitor, then the product’s variable cost might have problems.
Contribution Margin Formula
The following is the formula of Contribution Margin,
Contribution Margin Per Unit = Sale Price Per Unit – Variable Cost Per Unit
Total Contribution Margin = Total Sales – Total Variable Costs
Total Contribution Margin in Percentage = (Total Sales – Total Variable Costs) / Total Sale
This is quite straightforward. You could either calculate the contribution per unit or total contribution base on your requirement.
And if you want to calculate its ratios, you need to contribute to the sale.
Contribution Margin Example
Now let move to the example for your better understanding,
ABC is the company operating cloths manufacturing for the high class, and it has the transactions as the following,
Total sales per year are USD 2,000,000, and the cost per unit is USD 20. The variable cost is $10 per unit and the fixed cost for the years is USD 500,000.
Now let us perform calculation,
The variable cost per unit is USD 10. Therefore, the contribution per unit is USD 10. Then,
Total Sales 2,000,000
Total Variable Cost (1,000,000) 100,000*10
Contribution Margin is 1,000,000
If you want to calculate the contribution margin ratio, we could calculate the total contribution over sales like this.
1,000,000/2,000,000 or 50%
Contribution Margin Analysis
ABC contribution is quite good, and it is 200% over the fixed cost of USD 500,000. It might be because the ABC Cloths are unique and branding. That is why the customers don’t hesitate to pay for the clothes. As said in the exam, ABC clothes are for high-class people.
However, to perform better analysis, we probably need the data and information about the competitors in the market and industry average to assume how goods the margin of ABC over the competitors.
In other words, a high contribution margin means the variable cost of the product is low. And the rest of the cost is fixed cost. That is the main reason why the contribution is high.
Even the margin is good, ABC might still need to review and maintain its purchasing system to ensure that the materials are purchased at the lowest with acceptable quality.
It is essential to control both the cost and quality of clothes. The low price of material and better Contribution Margin. Another thing that ABC needs to review and making sure it is at the best performance in the production process. Labor is probably the most important cost and process in ABC as cloth manufacturing.
Frequency Question Relate to Contribution Margin
Is contribution margin the same as profit?
Gross profit is calculated by taking the total sales that the company made during the period less the total cost of goods sold that directly related to the goods sold during the period. And Net profit during the period is calculated by deducting the general and administrative expenses and tax expenses that include during the period from the company’s gross profit. On the other hand, the contribution margin is the margin of the product that the company has by deducting the variable cost from the net sales. The main purpose of calculating the contribution margin is to assess the amount required to cover the fixed costs to get the net profit.
Written by Sinra