Introduction to Contribution Margin Ratio.
The contribution ratio is the financial metric used by many companies, which helps decide whether to discontinue selling various products and services.
For example, suppose a company sells a certain product that has a positive contribution margin.
In that case, the following product might be making enough money to cover its shares of fixed costs, such as paying rent for the company building.
However, the analysis can also show that the product is not earning enough to cover its shares of variable costs, such as direct labor and utilities, and generate a profit.
Usually, the contribution margin ratio takes the analysis one step further to show the percentage of each unit sold that contributes to covering the company’s variable costs and profit.
Definition of Contribution Margin Ratio.
It often happens that a company looks at the minimum price at which a product could sell to cover the basic and fixed expenses of the business.
Fixed expenses do not vary with the increase or decrease in production, including rent of the building, various property taxes, various business insurance, and other specific costs that the company pays, regardless of whether the company is producing any units of product for sale.
This analysis of minimum sale price is also known as a break-even analysis.
Contribution margin is one of the important parts of this break-even analysis called dollar contribution per unit.
Experts calculate the contribution margin by first finding the variable cost per unit sold and subtracting it from the selling price per unit.
Variable costs fluctuate with the units produced and include raw materials, packaging, and the labor used to produce each unit.
This calculation also shows the part of sales revenue that is usually not consumed by the variable costs and is also available for satisfaction of fixed costs, also known as the contribution margin.
Typically, labor-intensive service businesses are turned up by the low contribution margin.
In contrast, high contribution margins are also widely spread in more capital-intensive industrial businesses that usually require expensive machinery and large production facilities.
Contribution margin analysis also helps companies to measure their operating loan capital. Those companies that sell products or services that generate higher profit with lower fixed and variable costs have very good operating loan capital.
Formula and calculation of Contribution Margin Ratio.
Formula and the result:
The formula of the contribution margin ratio is used to calculate the percentage of contribution margin, i.e. fixed expenses, or sales minus variable expenses, which are relative to the net sales, which are put into percentage terms.
Usually, the answer to this equation shows the total percentage of sales income, which covers the fixed expenses and profit after covering all variable costs of the produced product.
Calculation of Contribution Margin Ratio:
The following formula is used for calculating the contribution margin ratio:
Contribution margin ratio = contribution margin / sales
Where contribution margin = sales minus variable costs
The contribution margin ratio can help companies calculate and set targets for the profit potential of a given product.
How to actively improve contribution margin in your business?
The business has a wide range of options that include an increase in price, efficiency in operations, reduction in cost, or negotiating supplier discounts to improve the business contribution margin.
A price change is an easier way to improve the margin, but the business needs to evaluate whether the customer can pay more for the product.
Efficiency in operations requires a real focus on understanding all of the elements that produce the product and improving. It can be through technology, increasing capacity or even purchase of more productive equipment.
Cost reduction can be the most difficult option as it will most likely mean labor reduction or negotiation to spend less with your suppliers.
Fixed Cost vs. Variable Cost:
Items such as machinery are a very typical example of a fixed cost that usually stays the same regardless of the number of units sold needs one-time costs.
However, it becomes a small percentage of each produced unit’s cost as the number of units sold increases.
Other examples also include services and utilities that might be coming at a fixed cost and do not impact the number of production units or even sold units.
E.g., if the government is offering unlimited electricity at a fixed monthly cost of $100, then ten manufacturing units or 10,000 units will be having the same fixed cost towards the electricity.
If we take another example of fixed cost, a website hosting provider offers unlimited hosting space to its clients at a very fixed cost.
Whether the client is putting one or ten websites and uses 100 MB or 2 GB of the hosting space, the hosting cost remains the same.
In these scenarios, electricity and web-hosting costs would not consider the contribution margin formula as it represents a fixed cost. Monthly fixed rents or paid salaries to administrative staff also fall in the fixed cost category.
However, suppose the same electricity cost increases in proportion to the consumption, and the web-host charges increase based on the number of sites hosted and the space consumed.
In this case, the costs would be considered variable costs. Similarly, wages paid to the employees who will get paid based on the number of units they have manufactured or any of its variations are variable costs.
In such an item, each will be considered in the calculations of contribution margin.
Often fixed costs are considered as sunk costs that are once spent and cannot be recovered.
These components’ costs cannot be considered while making various decisions about cost analysis or profitability measures.
Various uses of contribution margin:
Contribution margin help’s the company management select from several possible products that can compete to use the same set of manufacturing resources.
It can be also be said that a company has a pen-manufacturing machine capable of producing both ink pens and ball-point pens, and management must choose the production of only one of them.
If the ink pen’s contribution margin is higher than that of a ball pen, then the former will be given preference for the production, which would be owing to its higher potential of profits.
Such decision-making technique is common to companies that manufacture a diversified portfolio of products.
Management is allocated for the most efficient resources to the products that have the highest potential of profit.
Investors and analysts may also attempt to calculate the contribution margin figure for the company’s most exclusive products.
For instance, if a beverage company has 15 different products, then the bulk of its profits may come from one specified beverage.
As with the company’s management, vigilant investors might closely monitor the contribution margin of a high-performing product relative to their other products, which be assessed its dependence on its star performer.
The company can steer its focus away from investment or expansion of the manufacturing of the star product, or there is an emergence of a competitor product, which might indicate that the profitability of the company and eventually the share price may get impacted.
Values indicating very low or negative contribution margin can be economically nonviable products discarded by manufacturing and sales.
Low contribution margins can be observed in the labor-intensive industry sectors like manufacturing as the variable costs are higher. In contrast, it is prevalent of the high values of contribution margins in the capital-intensive sectors.
The concept of applying contribution margin at various levels of manufacturing, business segments and products can be figured out by computing the entire corporate, for a particular subsidiary, for a particular business division or unit, for a particular center or facility, for distribution or sales channel, for a product line, or individual products.
How do we tackle with a negative contribution margin ratio when we are calculating our break-even point?
The negative contribution margin ratio usually indicates that your sales can exceed your variable costs and expenses. In other words, if you can increase your sales in the equal proportion as in the past, you might be experiencing larger losses. This also improves the Accounts receivable Turnover ratio.
According to my recommendation, it would be appropriate to calculate the contribution margin and contribution margin ratio for every product or service offered by you. It also comes under the suspicion that some of your items might be having positive contribution margins, but the margins are greater than the products with a negative contribution. You must be getting into the details.
It would be best if you would have a look at every customer. Perhaps if some customers are even buying in huge quantities, but these sales are not profitable. Have a look at which customers have positive contribution margins.
According to the definition, the ways for the elimination of the negative contribution margin can be-
1) Rise selling prices,
2) Reduction in variable costs,
3) Combine some of the first two.
If customers do not accept price increases to cover your variable costs, you are probably better off not having the sales. Remember that those selling prices must then cover the fixed costs and expenses after covering the variable costs.
A total negative contribution margin can also mean that your loss will be larger than the fixed costs and even expenses.
While setting up the prices or bidding for new work, you might think about the bottom line profits.
Many people also focus very much on the top line sales.
Why contribution margin ratio is important?
The contribution margin ratio provides close sight of how your company’s products and sales are fitting as the biggest picture of your business.
Suppose the contribution margin ratio for a particular product of your company is lower or negative.
In this case, it can also be a sign that the product might not helping your company in making a profit and should be sold at a very different price point.
It is also a very helpful metric for tracking overtime while looking at how sales affect profits.
Frequently Asked Questions.
What is the contribution margin ratio?
The CM ratio of a business is usually equal to its revenue. In accounting terms, “Sales” and less all variable costs. It can be one of the most popular methods in classification according to the dividing its revenue. It usually represents the marginal benefits of the production of one more unit.
How is contribution margin calculated?
The computing of the selling price per unit minus the variable cost per unit is also known as contribution margin.
Also known as dollar contribution per unit, the measure indicates how a particular product contributes to the company’s overall profit. Any remaining revenue left after covering fixed costs is the profit generated.
What is the break-even point?
The break-even point usually refers to the revenues necessary to cover a company’s total fixed and expenses for a specified period in accounting. This revenue can be stated in dollars (or other currencies), units, or even hours of services provided.
One of the basic calculations of the break-even point in sales dollars for a year is fixed expenses like fixed manufacturing, fixed SG&A, fixed interest for the year, divided by the contribution margin ratio.
The break-even point is the basic calculation of units sold for a year and some fixed expenses separated by the contribution margin per unit for a product.
My Name is Nadeem Shaikh the founder of nadeemacademy.com. I am a Qualified Chartered Accountant, B. com and M.Com. having professional and specialize experience in field of Account, Finance, and Taxation. Total experience of 20 years in providing businesses solution in Taxation, Accounting, and Finance with all statutory compliance with timely business performance Financials reports. You can contact me on [email protected] or [email protected]