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.
Read More: Market Orientation – What Is It, And How Does It Work?
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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When I was undergoing a significant financial crisis a few years back, I looked for the best investment apps to get my economic life back on track. But, as there were no good articles on this topic, I faced a lot of trouble figuring out the best investment app. That’s why we decided to shed a bit of light on this topic. Now, the best investment apps can handle your daily financial tasks without much drama. They can also help you trade stocks quickly, keep track of your spending habit, and can help you learn about the market. So, if you are looking for these apps, you are already one step ahead in the game. What Are The Best Investment Apps For 2021? The best investment apps that we will recommend on this list are the best for beginners and professionals alike. So, let’s have a look. 1: Invstr From real-life investing to help beginners make their way in the stock, market-you can get everything on this app. It is best investment apps on this list. 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Broad Range Of Investment Options – Using a top-rated platform, you can offer your clients a broad range of investment options; search the web for the best wealth management platform and see what they have to offer. Managed portfolios, managed funds listed securities, term deposits and annuities. SMSF – Your clients can experience the benefits of an SMSF without actually owning one, with low-cost investors who can eventually increase their portfolio and keep admin costs down. Managing CGT – Capital Gains Tax is not something you can afford to ignore and the top platform offers the potential to minimise CGT with tax optimisation capabilities. All Device Compatibility – As you would expect, the platform is all device compatible, and millions of people use their mobile device when surfing the web. Click here for a list of the best mobile apps for investors. 2. Delivering Value To Your Clients Your clients all have one thing in common, they are looking for the best value from their portfolio and by having access to cutting-edge software and powerful features on a secure platform, your clients will have the very best tools available. Enhanced portfolio management capability is how you provide your clients with the tools they need to be successful and there are Australian wealth generation platforms with bank-grade cyber-security. 3. Online Learning Resources Forging a working relationship with a leading Australian wealth generation platform allows you and your clients access to a huge library of learning resources; we are all on a lifetime journey of learning and having access to the best resources is essential. Technology is always developing and today’s generation of specific business software is about as good as it gets; financial advisers and fund managers should make use of the best platforms and tools to bring their clients the best possible investment opportunities. 4. Online Solutions As a financial adviser or fund manager, everything you need can be found with a single digital platform and Google can help you to find Australia’s leading provider of an investor platform. Take a look at the services and features on offer and once you are registered, you and your clients can take advantage of the many aspects on offer from Australia’s leading wealth generation platform. You owe your clients the best possible opportunities and by making good use of cutting-edge digital platforms, you are empowering your clients and helping them to generate wealth. How Can Wealth Management Platforms Shape Your Business Future? 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Investors can monitor and manage their portfolios from anywhere, anytime, using mobile apps or online portals. This accessibility fosters greater engagement and transparency between clients and their financial advisors. 4. Cost Efficiency Wealth management platforms often offer cost-effective solutions compared to traditional financial advisory services. Through automation and scalability, these platforms can lower down the payments, and the minimum amount of expenses is essential, making wealth management services more accessible to a broader range of investors. 5. Regulatory Compliance & Security With growing concerns around data privacy and regulatory compliance, wealth management platforms invest heavily in robust security measures and compliance frameworks. These platforms ensure that client data is protected and that all transactions adhere to regulatory standards, providing peace of mind to investors. 6. 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Inventory Reserve: What Is It, How It Works, Purpose, and Usage
Whether it is a big company or a small one, a successful company or a not-so-successful one, all face a situation where all the inventories are not sold. Some percentages of the inventory go bad or become obsolete for all. The inventory reserve of the business is and accounting technique and is also the estimate of the percentage of inventory that is unsold. The inventory reserve plays a big role in correctly valuing the inventory of the company. Hence, this also helps present a full picture of the company’s health, financial worth, and flexibility. In this article, you will learn about inventory reserve and how it works in the process of accounting. Apart from that, we will also explain the use of inventory reserve in accounting. Finally, we will show you the process of accounting for the inventory reserve of a business. What Is An Inventory Reserve? According to Investopedia, “An inventory reserve is a contra asset account on a company's balance sheet made in anticipation of inventory that will not be able to be sold. Every year, a company has an inventory that will not be able to be sold for various reasons. It may spoil, fall out of fashion, or become technologically obsolete. In anticipation of this, the company will create an entry on the balance sheet called inventory reserve.” The inventory reserve portion in the balance sheet consists of the company’s prediction of the inventory that will not be sold that year. While the company counts its inventory as an asset, it considers its inventory reserve as a contra asset. This is because the latter reduces the net amount of inventory assets of the company. The company creates the inventory reserve as an estimate of the company’s future inventory spoilage. The company brings out this estimation based on its past experiences. Furthermore, once the company identifies an inventory that it's unable to sell, it writes it down as an official recognition of the loss. Business managers of an organization use these data from previous years' inventory information. Hence, based on this, they make a judgment and decide on the size of the inventory reserve. What Is The Use Of An Inventory Reserve In Accounting? In general, businesses want to get an accurate picture of their inventory position. Hence, they try to estimate the amount of inventory that is not to be sold from the end of the company. This inventory which the company has written off is called the inventory reserve of the company. The accountant includes this data in the balance sheet. According to NetSuite.com, “Companies own raw materials, partially completed products, and finished goods. These items are all included in a company’s gross inventory. Business managers know that not all of their raw materials will be used, and not all of their finished goods will be sold. That reserve is deducted from the value of gross inventories to arrive at the company’s net inventory position. Net inventory is typically what appears on a company’s balance sheet.” During the accounting process, the business considers its inventory reserve as a “contra” asset in its balance sheet. This is because this amount actually reduces the gross inventory value to arrive at the company’s net inventory value. Since inventory accounts come naturally with a debit balance, as debit increases in the balance sheet, the inventory account value increases. On the other hand, inventory reserves, like contra-asset accounts, come with natural credit balances. Hence, the latter serves to reduce the value of the assets. How Does An Inventory Reserve Work? 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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Loan AspectsWhat FlexSalary Offers You?Loan Amount₹ 4000 - ₹ 2,00,000Loan Tenure10 months to 36 months (Based on the loan applied for)Rate Of Interest On loans10% to 12% per annumLoan Processing Fees₹ 650 only (One-time payable only upon Loan Disbursement)Collateral Or MortgageNo collateral requiredLoan Review TimeDepending upon the amount of the loan (may take from 5 minutes to 7 days)Late Payment Of The LoanUp to 5 %, depending on the type of loan applied for.Loan RepaymentLoan repayment is made automatically from the provided bank details as per the approved schedule. Repayment should be made through the mobile app of FlexSalary.FlexSalary Customer Care Number+91-40-4617-5151+919908935151+919100038349CIN NumberCIN U65923TG2016PTC110767AddressUnit A, 9th Floor, MJR Magnifique, Survey No 75 & 76, Khajaguda X Roads, Raidurgam, Hyderabad, Telangana – 500008. Is FlexSalary Safe? Yes. FlexSalary is fully legit and safe. The website is also safe to use as it is HTTPS-secured and SSL certified as well. However, regarding the customer service of the company, many borrowers of loans have complained. Despite that, as per our experience, we think the app works quite well and is legit. Furthermore, the company has a CIN number, and it is registered through the Reserve Bank of India. When Can Flex Salary Comes To Rescue? There are certain circumstances where flex salary comes to the rescue. You need to get through the possible solutions that can make things easier for you. You need to follow certain steps that can make things easier for you to attain your requirements with ease. 1. Don’t Have Collateral Flex salary will offer you unsecured lines of credit loans. You do not have to pledge to your assets if the collateral gets approved for your loan. You need to get through the complete process that can develop things in perfect order. 2. If Your CIBIL Score Is Low Flexsalary will not focus on your CIBIL score to provide you with the loan you need in times of crisis. If you have a low CIBIL score then you must go through the best flex salary options to meet your requirements with ease. 3. Need An Emergency Cash If you are facing a medical emergency and you need the loan on an immediate basis, then you must consider using Flex salary. You need to identify the perfect solution that can make things lucid for your business development. 4. Loan Is Rejected By Banks If you have low income, bad credit history, and banks have rejected your loans, then Flex salary can be the best option for you. Flex salary will offer you loans at times of crisis. You do not have to pay any kind of interest to get these loans. 5. Don’t Want To Pay Excess Interest If you are afraid of bearing the higher interest rates on your loan, then Flex interest loan amounts can be one of the best options for you. If you do not use money, you do not have to pay the interest. 6. If You Need A Loan For A Lifetime Flex salary personal line of credit you can receive for a lifetime. Your credit limit gets filled up once you pay back the withdrawn amount. It works almost like that of a credit card. You need to identify the perfect solution that can make things easier for you. Can You Get An Instant Personal Loan For Your Marriage From Flex Salary? Yes!! You can receive an instant personal loan for your marriage when you opt for the flex salary. If you have an urgent need for cash in order to meet your marriage-related expenses, then Flex salary can be of great help to you. You will get the help for money within a few hours. It can help you to get the desired amount of money for a personal loan when you need it the most from your endpoints. How To Do FlexSalary Login? – Steps To Follow The following are the steps through which you can apply for a loan through FlexSalary: Step 1: Visit their official website and click on "Apply for an Instant Loan." Step 2: You will get a form on the next page, which you will need to fill out and add information into. Add all the documents required to get a loan from the FlexSalary platform. Step 3: There are various verification processes available. You can either apply for Net Banking Verification or you can upload the documents on your own. Once you upload the documents, they will verify your credentials and will tell you what you are eligible for. Through the app, it is almost the same. All you need here is to download the app and register your account with it. 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Self-Employed Individuals- No loan is allowed for self-employed- The applicant must have an employment FlexSalary Reviews From Customers The following are some of the useful customer reviews regarding FlexSalary that you can benefit from: Syed Abrar: “I'm very happy much satisfied with the service Uma Maheshwari are very nice she was helped me through out the process I got the loan amount as soon as the documents were collected best app.” Manjeera Dhfm: “My credit limit was activated in 1day. But I was not able to withdraw amount,due to my account issue, then customer support team interacted with me continuously and solved the problem. Thank you team. They are well mannered employee's who have patience to listen the issue and resolve it quickly.” Selva Raj: “Last month urgently required some amount, one of my friend referred me Flexsalary and they had treat me as a friend and pay me the amount with very minimum documents. 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