Contribution margin is a concept that is often used in managerial accounting to analyze the profit level of a product. The contribution margin of a product is calculated using the formula P - V where P is the price of the product and V is the variable cost (the cost associated with the resources used to make a particular product). In some cases, this value can also be referred to as the gross operating margin of a product. Contribution margin is a useful concept for calculating the amount of money a business can make from selling products to pay fixed costs (costs that don't change based on production) and make a profit.
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Part 1 of 2: Calculating a Product's Contribution Margin
Step 1. Determine the price of the product
The first variable you should look for to calculate the contribution margin equation is the selling price of the product.
Let's work on an example problem in this section. For the purposes of our example, suppose we run a factory that produces baseball. If we were to sell baseballs for $3 per ball, we would use $3 (Rp40,500.00) as the selling price of our baseball.
Step 2. Determine the variable costs associated with the product
Apart from product costs, the only other variable we should look for to determine the contribution margin is the total variable costs. Product-related variable costs are costs that change with changes in the amount of production produced, such as salaries, raw materials, and utilities such as electric power, water, and so on. The more products that are made, the greater this cost - because these costs vary, we call them variable costs.
- For example, in our baseball factory example, suppose the total cost of the rubber and leather materials used to make baseballs last month was $1,500. In addition, we pay our workers $2,400 (Rp32,400,000) and the factory utility bills total $100 (Rp1,350,000). If the company produces 2,000 baseballs that month, the variable cost of each baseball is $4,000/2,000 (Rp54,000,000,00/2,000) = $2 (Rp 27,000, 00).
- Note that in contrast to variable costs, fixed costs are costs that do not change even though the volume of production changes. For example, the rent our company pays for a factory building remains the same, no matter how many baseballs are produced. Thus, rental costs are included in fixed costs. Fixed costs are not included in the calculation of the contribution margin. Other common fixed costs include buildings, machinery, patents, etc.
- Utilities can be included in both fixed and variable costs. For example, the amount of electricity used by a store during operating hours remains the same whether or not goods are sold. However, in a production plant, electricity can be a variable depending on the number of products produced. Determine if you have any utilities that fall into the variable cost category.
Step 3. Subtract the variable cost per unit from the price
Once you know the variable costs and price of a product, you are ready to calculate the contribution margin by simply subtracting the variable costs from the selling price. Your calculation results show the amount of money from the sale of a single product that the company can use to pay fixed costs and make a profit.
- In our example, it is very easy to calculate the contribution margin of each baseball. Just subtract the variable cost per ball ($2 or IDR 27,000, 00) from the price per ball ($3 or IDR 40,500) to get 3 – 2 (Rp 40,500.00 – Rp 27,000, 00) = $1 (Rp13,500, 00).
- Note that in real life, the contribution margin can be found in business income statements, which are documents a company publishes to investors and the IRS.
Step 4. Use the contribution margin to pay for fixed costs
A positive contribution margin is almost always a good thing because sales of the product cover its variable costs and contribute a certain amount to its fixed costs (hence the name contribution margin). Since the fixed costs do not increase even though the volume of production increases, after the sales proceeds can cover the fixed costs, the contribution margin of the remaining products sold becomes pure profit.
In our example, each baseball has a contribution margin of $1. If the cost of leasing the factory is $1,500 and there are no other fixed costs, only 1,500 baseballs need to be sold each month to cover fixed costs. After that, each baseball sold generates a profit of $1
Part 2 of 2: Using Contribution Margin
Step 1. Find the contribution margin ratio by dividing the contribution margin by the price
Once you find the contribution margin for a particular product, you can use it to do some basic financial analysis work. For example, you can find the contribution margin ratio, which is the related value, by simply dividing the contribution margin by the product price. The ratio represents the share of each sale that makes up the contribution margin - in other words, the share used for fixed costs and profits.
- In our example above, the contribution margin per ball is $1 (Rp13,500.00) and the price is $3 (Rp40,500.00). In this case, the contribution margin ratio is 1/3 = 0, 33 = 33%. 33% of each sale is used to pay fixed costs and earn profits.
- Note that you can also find the contribution margin ratio for more than one product by dividing the total contribution margin for all products by the total price of all products.
Step 2. Use the contribution margin for a quick break even analysis
In a simple business scenario, if you know the contribution margin of a company's products and the company's fixed costs, you can quickly estimate whether the company is profitable or not. Assuming that the company does not suffer a loss in sales, all the company has to do to make a profit is to sell a certain amount of product in order to cover its fixed costs-the proceeds from the sale of the product can be used to pay for the variable costs of the product. If the products sold are able to cover their fixed costs, the company starts to make a profit.
For example, suppose our baseball company's fixed costs are $2,000 (Rp.27,000,000) and not $1,500 (Rp.20,250, 00) as stated above. If we were still selling the same number of baseballs, we would make $1 (Rp13,500) × 1,500 = $1,500 (Rp20,250, 000). This is not enough to cover the fixed costs of $2,000 (Rp.27,000,000.00) so in this situation, we loss.
Step 3. Use the contribution margin (and its ratio) to critique the business plan
Contribution margin can also be used to help determine how to run a business. This is especially true if the business is not making a profit. In this case, you can use your contribution margin to help define new sales targets or look for alternatives to reduce your fixed or variable costs.
- For example, it can be used to identify expenses that need to be reduced. Suppose we are tasked with addressing a budget shortfall of $500 (Rp6,750,000,00) from the example above. In this case, we have several options. Since the contribution margin is $1 per baseball, we can try selling another 500 baseballs. However, we can also move our operational activities to buildings with lower rental costs so as to reduce fixed costs. We can even try using less expensive materials to reduce our variable costs.
- For example, if we could deduct $0.5 ($6,750) from the cost of producing each baseball, we'd make a profit of $1.5 ($20,250) instead of $1 ($1,500). So, if we sell 1,500 balls, we will make a profit of $2,250 (Rp30,375,000, 00).
Step 4. Use the contribution margin to prioritize products
If your company makes more than one product, the contribution margin for each product can help you determine the number of products to produce. This value is especially important if your products use the same ingredients or go through the same manufacturing process. In this situation, you should prioritize one product so you want to choose the product that has the largest contribution margin.
- For example, suppose our factory produces soccer balls and baseball balls. Production of soccer balls costs more, at $4 (Rp54,000), but can be sold for $8 (Rp108,000) per ball. Soccer balls provide a larger contribution margin of $8 - $4 ($108,000 – $54,000) = $4 ($54,000). If soccer balls and baseballs were made of the same leather type, we would definitely prioritize the production of soccer balls - because we get a contribution margin that is 4 times greater than a baseball which only provides a contribution margin of $1 (Rp13,500.00).
- Most importantly, in this situation, soccer ball provides a higher contribution margin ratio of 0.5 compared to baseball which is only 0.33. This means that soccer is more profitable for the company.
