What is a measure of the contribution margin required to deliver a good or service as the business grows and volumes increase?

When taking a look at how your business is doing financially, it’s tempting to focus all your attention on the “bottom line.” In other words, are you turning a profit or not? If the answer is yes, many business owners might stop there, pat themselves on the back, and vow to keep doing more of the same. But there’s always room for improvement. And the things you’re doing now may not continue to work as the business grows. One metric to keep an eye on, particularly for businesses that produce physical products, is contribution margin. 

A business’ contribution margin shows how much money is left over after variable costs are removed to cover fixed costs. It’s a metric that’s rarely shared publicly but rather is used by managers and leadership to make decisions. 

The overarching goal of the contribution margin to help these key players improve the production process by analyzing their variable costs and (hopefully) finding ways to bring them down. 

Contribution Margin Formula 

The formula for contribution margin is simple and just involves a little subtraction. Here’s what it looks like: 

The two primary variables here are net sales and variable costs, both of which can be found on an income statement. 

Net Sales 

Net sales is often referred to simply as revenue. It’s all the money your business brought in, excluding only allowances and returns. It’s usually the first thing you see on an income statement before all expenses are taken out to get to the “bottom line.” 

Variable Costs 

Variable costs also live on the income statement, but they’re not as easy as net sales to find. Instead, they’re usually listed as line items within cost of goods sold, right alongside fixed costs. 

So finding your variable costs may involve adding up all the relevant line items from your income statement and then subtracting that amount from your net sales. 

Variable costs, generally speaking, are those expenses that fluctuate from month to month, usually in direct relation to your sales. For example, if you run a dog grooming salon and have a strong month with more pups than normal stopping by, you’ll need to buy more shampoo to keep up with demand. The shampoo is a variable cost in this scenario. 

Common examples of variable costs include:  

• Raw materials 
• Labor costs
• Shipping costs

Difference Between Fixed & Variable Costs

So if variable costs go up or down depending on how your business does that month, what are fixed costs? Fixed costs are, as the name implies, relatively static. Whether you have a great month or a terrible month, you’ll still need to pay all your software subscriptions, rent, and phone bills. 

The division between fixed and variable costs can depend largely on your business. A consulting business with a traditional office space may consider the water bill, for example, a fixed cost. But a dog grooming business that uses water to provide their service would almost certainly consider the water bill a variable cost. The more dog washes they do, the higher that bill. 

This is why parsing variable costs from fixed costs is a relatively manual process that the income statement doesn’t naturally break out. 

Contributed Margin Example

Let’s dig a little deeper into our dog grooming example to see the contribution margin at work. Let’s say that Pup n Suds Grooming brought in $40,000 in revenue last month. When they look at their income statement, they see the following variable costs: 

• Materials (ex. Shampoo): $1,500 
• Payroll: $18,000
• Water Utilities: $1,200
• Dog Treats: $200 

Adding these variable costs up, Pup n Suds spent $20,900 on variable costs. If we subtract that from the $40,000 they brought in through sales, we know that they have $19,100 left over to cover fixed costs (and hopefully still have some left over after that). 

$40,000 – $20,900 = $19,100

High vs. Low Contribution Margins

Generally speaking, you want your contribution margin to be as high as possible. A high contribution margin means that you make more from your products than they cost to produce and are in a strong position to cover your fixed costs. A low contribution margin simply means that your margins are slim and that you’ll need to sell a high volume to make a decent profit and pay your fixed costs. 

Your contribution margins can also be assessed on a product-specific level. So if you produce a wide variety of products, calculating the contribution margin for each product will help you understand which ones are your top performers and which ones you should consider dropping. 

Of course, a product’s contribution margin is simply one factor to consider when evaluating your product line. Attempting to trim costs may not be the best route for luxury products with low contribution margins, but raising prices could be a better alternative. Businesses should take their customer expectations, brand, and internal standards into account as well. 

Other Relevant Formulas

The main drawback of the contribution margin formula is that it leaves business owners with a dollar amount. So deciding what a strong margin looks like is subjective. Luckily, there are a few other ways to look at contribution margin that can help business owners look at their overall contribution margin and product-specific margins with more objectivity. 

Contribution Margin Per Unit

One of the best ways to track the performance of specific products is to calculate the per-unit contribution margin. This metric essentially shows you how much money you’ll earn on each sale, once the cost of producing that item (its associated variable costs) has been subtracted. 

Here’s the formula: 

The key to using the formula above is to find only the revenue that comes from sales of a specific product or product line, along with that product’s specific variable costs. This can be a little harder to parse out than simply looking at an income statement. 

Contribution Margin Ratio

To build on the per-unit contribution margin metric, business owners can also find their contribution margin ratio. The benefit of ratios is that they take dollar amounts out of the picture, allowing you to compare product margins side by side—without taking sales volume into account. 

Here’s the formula: 

Sales volume is still an important facet of contribution margin to keep in mind, but the ratio allows you to quickly compare your products. It gives you another lense through which you can view your financial information and make informed decisions. 

Want to learn more about how to manage your business? Make sure to check out the ScaleFactor blog.

Contribution margin (CM), or dollar contribution per unit, is the selling price per unit minus the variable cost per unit. "Contribution" represents the portion of sales revenue that is not consumed by variable costs and so contributes to the coverage of fixed costs. This concept is one of the key building blocks of break-even analysis.[1]

In cost-volume-profit analysis, a form of management accounting, contribution margin—the marginal profit per unit sale—is a useful quantity in carrying out various calculations, and can be used as a measure of operating leverage. Typically, low contribution margins are prevalent in the labor-intensive service sector while high contribution margins are prevalent in the capital-intensive industrial sector.

Purpose

In Cost-Volume-Profit Analysis, where it simplifies calculation of net income and, especially, break-even analysis.

Given the contribution margin, a manager can easily compute breakeven and target income sales, and make better decisions about whether to add or subtract a product line, about how to price a product or service, and about how to structure sales commissions or bonuses.

Contribution margin analysis is a measure of operating leverage; it measures how growth in sales translates to growth in profits.

The contribution margin is computed by using a contribution income statement, a management accounting version of the income statement that has been reformatted to group together a business's fixed and variable costs.

Contribution is different from gross margin in that a contribution calculation seeks to separate out variable costs (included in the contribution calculation) from fixed costs (not included in the contribution calculation) on the basis of economic analysis of the nature of the expense, whereas gross margin is determined using accounting standards. Calculating the contribution margin is an excellent tool for managers to help determine whether to keep or drop certain aspects of the business. For example, a production line with positive contribution margin should be kept even if it causes negative total profit, when the contribution margin offsets part of the fixed cost. However, it should be dropped if contribution margin is negative because the company would suffer from every unit it produces.[2]

The contribution margin analysis is also applicable when the tax authority performs tax investigations, by identifying target interviewees who have unusually high contribution margin ratios compared to other companies in the same industry.[3]

Contribution margin is also one of the factors to judge whether a company has monopoly power in competition law, such as use of the Lerner Index test.[3][4]

Contribution

The Unit Contribution Margin (C) is Unit Revenue (Price, P) minus Unit Variable Cost (V):

C = P − V {\displaystyle C=P-V}

The Contribution Margin Ratio is the percentage of Contribution over Total Revenue, which can be calculated from the unit contribution over unit price or total contribution over Total Revenue:

C P = P − V P = Unit Contribution Margin Price = Total Contribution Margin Total Revenue {\displaystyle {\frac {C}{P}}={\frac {P-V}{P}}={\frac {\text{Unit Contribution Margin}}{\text{Price}}}={\frac {\text{Total Contribution Margin}}{\text{Total Revenue}}}}

For example, if the price is $10 and the unit variable cost is $2, then the unit contribution margin is $8, and the contribution margin ratio is $8/$10 = 80%.

Contribution margin can be thought of as the fraction of sales that contributes to the offset of fixed costs. Alternatively, unit contribution margin is the amount each unit sale adds to profit: it is the slope of the profit line.

Cost-Volume-Profit Analysis (CVP): assuming the linear CVP model, the computation of Profit and Loss (Net Income) reduces as follows:

PL = TR − TC = ( P ) × X − ( TFC + TVC ) = C × X − TFC {\displaystyle {\begin{aligned}{\text{PL}}&={\text{TR}}-{\text{TC}}\\&=\left(P\right)\times X-\left({\text{TFC}}+{\text{TVC}}\right)\\&=C\times X-{\text{TFC}}\end{aligned}}}

where TC = TFC + TVC is Total Cost = Total Fixed Cost + Total Variable Cost and X is Number of Units. Thus Profit is the Contribution Margin times Number of Units, minus the Total Fixed Costs.

The above formula is derived as follows:

From the perspective of the matching principle, one breaks down the revenue from a given sale into a part to cover the Unit Variable Cost, and a part to offset against the Total Fixed Costs. Breaking down Total Costs as:

TC = TFC + V × X {\displaystyle {\text{TC}}={\text{TFC}}+V\times X}

one breaks down Total Revenue as:

TR = P × X = ( ( P − V ) + V ) × X = ( C + V ) × X = C × X + V × X {\displaystyle {\begin{aligned}{\text{TR}}&=P\times X\\&={\bigl (}\left(P-V\right)+V{\bigr )}\times X\\&=\left(C+V\right)\times X\\&=C\times X+V\times X\end{aligned}}}

Thus the Total Variable Costs TVC = V × X {\displaystyle {\text{TVC}}=V\times X}

PL = TR − TC = ( C + V ) × X − ( TFC + V × X ) = C × X − TFC = TCM − TFC {\displaystyle {\begin{aligned}{\text{PL}}&={\text{TR}}-{\text{TC}}\\&=\left(C+V\right)\times X-\left({\text{TFC}}+V\times X\right)\\&=C\times X-{\text{TFC}}\\&={\text{TCM}}-{\text{TFC}}\end{aligned}}}

Combined Profit Volume Ratio can be calculated by using following formula

Examples

The Beta Company's contribution margin for the year was 34 percent. This means that, for every dollar of sales, after the costs that were directly related to the sales were subtracted, 34 cents remained to contribute toward paying for the indirect (fixed) costs and later for profit.

Contribution format income statements can be drawn up with data from more than one year's income statements, when a person is interested in tracking contribution margins over time. Perhaps even more usefully, they can be drawn up for each product line or service. Here's an example, showing a breakdown of Beta's three main product lines.

Although this shows only the top half of the contribution format income statement, it's immediately apparent that Product Line C is Beta's most profitable one, even though Beta gets more sales revenue from Line B (which is also an example of what is called Partial Contribution Margin - an income statement that references only variable costs). It appears that Beta would do well by emphasizing Line C in its product mix. Moreover, the statement indicates that perhaps prices for line A and line B products are too low. This is information that can't be gleaned from the regular income statements that an accountant routinely draws up each period.

Contribution margin as a measure of efficiency in the operating room

The following discussion focuses on contribution margin (mean) per operating room hour in the operating room and how it relates to operating room efficiency.

A surgical suite can schedule itself efficiently but fail to have a positive contribution margin if many surgeons are slow, use too many instruments or expensive implants, etc. These are all measured by the contribution margin per OR hour. The contribution margin per hour of OR time is the hospital revenue generated by a surgical case, less all the hospitalization variable labor and supply costs. Variable costs, such as implants, vary directly with the volume of cases performed.

This is because fee-for-service hospitals have a positive contribution margin for almost all elective cases mostly due to a large percentage of OR costs being fixed. For USA hospitals not on a fixed annual budget, contribution margin per OR hour averages one to two thousand USD per OR hour.

See also

• Break-even (economics)
• Cost–volume–profit analysis
• Gross margin

References

1. ^ a b Farris, Paul W.; Neil T. Bendle; Phillip E. Pfeifer; David J. Reibstein (2010). Marketing Metrics: The Definitive Guide to Measuring Marketing Performance. Upper Saddle River, New Jersey: Pearson Education, Inc. ISBN 0-13-705829-2. The Marketing Accountability Standards Board (MASB) endorses the definitions, purposes, and constructs of classes of measures that appear in Marketing Metrics as part of its ongoing Common Language: Marketing Activities and Metrics Project.
2. ^ Hansen,Don R., and Maryanne M. Mowen, Managerial Accounting p.529, at http://www.usdoj.gov/atr/public/speeches/future.txt
3. ^ a b Tat Chee Tsui. "Interstate Comparison—Use of Contribution Margin in Determination of Price Fixing." Pace International Law Review (Apr 2011), at: http://works.bepress.com/tatchee_tsui/2
4. ^ Motta, M. Competition Policy: Theory and Practice (Cambridge 2004), P.110.
5. ^ Macario, A. "Are Your Hospital Operating Rooms "Efficient"?" Anesthesiology 2006; 105:237–40.

Other sources

• Cost-Volume-Profit Analysis; Chapter 11 at MAAW
• Cost-Volume-Profit Analysis at CliffNotes
• Cost-Volume-Profit Analysis at Answers.com

External links

• MASB Official Website

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