Profit forms the core of a business and is the best indicator of how successful a business is. One look at the Profit-margin of a business gives experts an idea about how well the business is doing commercially.
When it comes to businesses dealing with multiple products or services, it becomes essential to understand the individual profitability of a Product or Service from amongst the pool of products or services that it offers and it is at this junction that Contribution Margin – a very important tool of Cost accounting- comes into the picture.
Though it can be interpreted and defined in multiple ways, one of the most common and simple definitions of Contribution Margin can be the value left after the total variable costs of the product or service is subtracted from the total sales price.
The variable costs would include every cost incurred while manufacturing the product – from labor to raw material costs to overheads and any others too – and would differ according to the quantity of products manufactured. An important thing to keep in mind is that fixed costs, such as rent and salaries, are not taken into account when calculating Contribution Margin.
For a Contribution margin to be acceptable, it should not just be able to cover the fixed costs for that product or service but also have the surplus left. This surplus is then categorized as profits.
Though the concept allows businesses to determine the profitability of individual products or services, it finds itself being used not just in individual products or services but also in product lines, subsidiaries, distribution channels, customer sales, and for the whole business too.
How to calculate Contribution Margin?
A company, called XYZ, sells a product for $250. The cost of purchasing the raw materials is $100, the packaging is 10$ and transportation is $10. The contribution margin for this particular product would then be calculated as follows:
Contribution Margin = Sales price ($250) – Variable costs {raw material costs ($100) + Packaging ($10) + Transportation ($10)}
Thus, from the above calculation, the margin comes to $130.
Which is better – a higher contribution margin or a lower contribution margin?
This one is a no-brainer and is easy to understand, even for novices. The higher the Contribution margin of a product or service, the more profitable it is for a business and the lower the margin, the less profit it brings in for the business. To explain, the higher value of contribution margin indicates that the cost of creating the product or service is substantially less than the total sales price and thus brings in profit for the business and vice versa for products or services with low contribution margin.
Is Contribution Margin important?
Yes, it is. For businesses dealing with multiple products or services, calculating the Contribution margin of an individual product or service becomes essential for businesses as it helps them understand the overall contribution to sales from that particular product or service and plays a crucial role in making business decisions regarding that particular product or service.
With this information in hand, they can then examine products or services that have consistent low or negative Contribution Margins and take steps to either reduce their total variable costs or increase the selling price (For products or services that have fixed costs that are equivalent to sunk costs that cannot be reduced) so as to have an acceptable Contribution margin for that particular product or service.
Once either of the above measures is adopted, businesses can then keep a constant watch on the products or services with low contribution margins, and decide whether it is feasible to continue the product or service or drop it altogether from their offering.
Another important use of Contribution Margin is while calculating the Target level of sales or Break-even point of sales. A simple explanation for this would be that if the business expenses for a particular product are $500 per month and the revenue generated from the same product is $500 per month, then we can safely say that the business is at the break-even point of sales for that particular product.
Though it is not making profits, it is making enough money to cover the expenses. Now that businesses have the breakeven point of sales and the contribution margin figures in hand, they can try to increase the margin and thus reduce the breakeven point of sales. Increasing the contribution margin would imply that businesses would need to generate less revenue to break even and thus make more profits.
Mistakes to avoid while calculating Contribution margin
Though it looks easy to calculate, many businesses fail to accurately calculate it since a few fixed costs are miscalculated as variable costs. For example, the cost of running variable departments such as Marketing, Operations and sales is considered fixed costs.
However, in reality, there might be a small commission given to the sales department for a fixed percentage of sales generated. This additional commission, which in reality is the variable cost, gets accidentally clubbed with fixed costs and thus affects the Contribution margin.
Another common mistake that business make is to discontinue a product or service that have low contributing margin without factoring in how much-fixed costs they consume. There might be cases when a product or service has a low contributing margin but uses marginal fixed costs and thus still brings in some profit for the business. Thus, relying entirely on low contribution margin while deciding whether to continue a product or service is not advised by experts.
Though an effective tool to find out about the amount of revenues available to cover fixed costs of producing a product or service, contribution margin has its limitations too and thus should not be the only criteria when deciding the fate of a product or service.
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