Contribution Margin: What Is It, Overview, Examples, And More
Businesses use the contribution margin to measure how profitable it is to produce a product. Here, the business finds out how much revenue is left after the deduction of variable costs like transportation expenses and raw materials. A product is only profitable if the left-over revenue, after the deduction of variable costs, is higher than the fixed costs (insurance and salaries) of the business.
In this article, you will learn about what contribution margin is and how it helps to measure the profit of a company. In addition to this, we will also share with you the formula for contribution margin and how to calculate using that formula. In the latter case, we will explain with the help of an example. You will also learn the uses of contribution margins in business. Finally, we will discuss some ways to improve this margin for businesses.
What Is The Contribution Margin?
According to Investopedia,
“The contribution margin can be stated on a gross or per-unit basis. It represents the incremental money generated for each product/unit sold after deducting the variable portion of the firm’s costs. The contribution margin is computed as the selling price per unit minus the variable cost per unit.”
The term contribution margin is also known as dollar contribution per unit. The factor also helps the business to measure how much a particular product contributes to a company’s overall profit. The measure helps in getting an idea of the profit potential of a particular product that the company offers.
Apart from that, it also helps in showing the portion of sales with the help of which the company is covering its fixed costs. After the company has covered all its fixed costs, the amount left is the profit that the company made in the given timeframe.
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How To Calculate The Contribution Margin?
To calculate the contribution margin of a business, you will first need to calculate the sales revenue of the business. Then, you will need to subtract the variable costs of the business from the sales revenue. The amount that is left is used to cover the company’s fixed costs. Some of the major examples of fixed costs include rent, salaries, insurance, etc.
This resultant amount that the company is using to fulfill the fixed costs is the contribution margin of the company.
Here is the formula for the contribution margin of a company:
| Contribution Margin = Net Sales Revenue of the business – Variable Costs of the business Or, Contribution Margin = Fixed Costs of the business + Net Income of the business |
Here is the formula for the contribution margin ratio:
| Contribution Margin Ratio = (Net Sales Revenue of the business – Variable Costs) / (Sales revenue of the business) |
A Simple Example Of The Contribution Margin
You can understand the contribution margin here with the help of a simple example –
A Machine for manufacturing pencils is priced at $10,000. (Fixed Cost)
The cost of manufacturing one pencil requires $0.2 of wood, pigment, color, etc.
The electricity charges that go for manufacturing one pencil is $0.1.
The labor charge is $0.3 for manufacturing one pencil.
Therefore, the variable cost for manufacturing one pencil = $ (0.2+0.1+0.3) = $0.6 per pencil.
So, the cost of manufacturing 10,000 pencils = $0.6 x 10,000 = $6,000.
Hence, the total manufacturing cost = the variable cost + fixed cost
= $6,000 + $10,000 = $16,000.
Therefore, the cost of one pencil = $16,000 / 10,000 = $1.6.
Hence, if the selling price of one pencil is $2, then profit = $2 – $1.6 = $0.4 per pencil.
However, to measure contribution costs, we will need to consider only variable costs. Therefore, the incremental profit = $2 – $0.6 = $1.4 per pencil.
What Are The Uses And Applications Of Contribution Margin?
According to the Corporate Finance Institute,
“It is important to assess the contribution margin for break-even or target income analysis. […] To resolve bottlenecks, contribution margin can be used to decide which products offered by the business are more profitable and, therefore, more advantageous to produce, given limited resources. Preference is given to products that provide a high contribution margin.”
Hence, businesses can use this to find out those products that bring the highest profits despite consuming the same set of manufacturing resources. Let’s say a company manufactures two types of pencils. The one that brings the highest profit will be given the higher production preference. This also helps the management to allocate resources in the most efficient manner.
How To Improve Contribution Margin?
According to TheForage.com,
“The more revenue available after variable costs are covered, the better, especially considering how expensive fixed expenses like rent and salaries can be. At the very least, a product must have a positive contribution margin to be worth producing. So, even if the product isn’t that profitable, the company can break even as long as the margin is high enough to cover fixed expenses.”
In addition to this, a business can also improve its contribution margins if it adjusts its production costs and considers making its processes more efficient.
The company can also reduce its variable costs, such as by lowering the expenses of factors like shipping and marketing. The company can reduce costs by choosing better and more affordable alternatives. Apart from that, the company can also find ways to improve its revenues. However, these need to be done with care, as improper implementation can backfire for the company.
Read More: Market Cannibalization – Definition, How Does It Work, Example, And More
Wrapping Up
Hope this article was helpful for you to understand the concept of contribution margin. You can see from this article that the contribution margin is nothing but the portion of a product’s sales revenue, which is not taken up by variable costs. Hence, this left-over value contributes to the fixed costs of the company.
Companies that are labor-intensive (the ones with small fixed expenses) have low contribution margins. On the other hand, the ones that are capital-intensive, such as industrial companies with higher fixed costs, have high contribution margins. Do you think that this margin is a very important indicator to understand a company’s profit? Share your answers with us in the comments section below.
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Indeed.com explains – “An inventory reserve in accounting is an entry on a business's balance sheet that anticipates the company's unsold inventory. Accountants consider inventory as an asset on their balance sheet. An asset is any item or resource that a company owns and has the potential to generate economic value, such as revenue.” Inventory also falls under this asset category. Also, as per the need for good accounting principles, businesses need to report their assets in such a way that they are close to their actual value. Hence, if a business wants to calculate the net value of its inventory, it needs to account for the loss of inventory and make it an estimate. As per Generally Accepted Accounting Principles (GAAP), an inventory reserve is a part of inventory accounting. If a business wants to track its inventory reserve, it will thus be able to make an accurate representation of its assets on the balance sheet. The usefulness of an asset is only when it has a future value to the business. There is always a part of the inventory of a company that remains unsold every year. Hence, the company decides not to include the entire inventory amount as an asset on the balance sheet. To create an accurate value, the company subtracts the inventory contra asset account value from the inventory asset entry. The resulting value is the estimate that the company will sell to create value for the business. If the company does not include the inventory reserve entry, the company will end up overstating the value of its assets. Accounting For Inventory Reserves: Special Considerations According to GAAP standards (which is the industry standard for accounting), inventory reserve is a conservative methodology for entry. This is because the company's attempt, in this case, is to predict the losses for the inventory even before the company has confirmed the loss. In general, inventories consist of goods with future value for the company. Hence, these goods are called assets. However, according to conservative accounting principles, it is important to report assets close to their current value. Hence, it gets easier for the company to make estimations. Summing Up Hope this article was helpful for you in getting a better understanding of how an inventory reserve works with accounting. You can see from here that it is important for the company to consider inventory reserve as a contra asset. This helps the company to get an accurate representation of the assets that it will sell in the future. Do you have more information to add regarding inventory reserve? Consider sharing with us in the comments section below. Enrich Youself With More Financial Article By Clicking Below!! Equity Theory: A Balancing Act for Modern Workplaces Supply Chain Risk Management: Effective Strategies To Reduce It What Is A Distribution Channel? 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Dec 29, 2023