The Contribution Margin is a significant financial metric that is sometimes neglected by managers. While profit margin is one we usually hold very important, it gives information only on the amount with which revenues exceed costs. On the other hand, Contribution Margin provides us with a way to see how exactly each separate product contributes to the company’s bottom line.
What is the Contribution Margin?
The Contribution Margin (CM) investigates the residual margin after we deduct variable expenses from revenues. The total Contribution Margin can be compared to Fixed Costs to see if the current pricing and cost structures are profitable. Therefore, the calculation does not include any fixed overheads.
The Contribution Margin analysis technique is widely used when comparing acquisition targets to see if they generate enough profit to be a worthy purchase.
We use the metric to get the portion of sales that is not used up by the Variable costs and contributes towards the firm’s Fixed costs.
Labor-intensive industries where Fixed costs and investments in machinery are minimal operate with a low contribution margin. In contrast, capital-intensive companies with significant investments and high fixed costs operate at a high Contribution margin.
We can use the metric to price a product, decide whether to add a product to a product line, how to structure sales commissions.
Companies should perform proper Contribution Margin Analysis, as it provides a critical view over profit and encourages management to manage the cost structure better.
Contribution Margin Calculation
We can calculate the Contribution margin on a gross or a per-unit level.
For total contribution we use the following formulas for the CM and the CM ratio:
If we want to look at the values on a per-unit basis, we can amend the equations and use these:
The Contribution Margin can be calculated at various levels of aggregation, from a single product to a product line, to the whole company.
To ensure we calculate the metric accurately, we need to provide correct distinguishment between Fixed costs and Variable costs. Generally, costs that increase with units produced are variable. On the other hand, costs independent from the volume are usually fixed. Fixed costs are also sometimes referred to as sunk costs, as once we spend them, we can’t recover them.
Margin of Safety
It is hard to forecast sales volumes, and managers tend to be a little over-optimistic when preparing budgets. The margin of safety is a crucial part of the Contribution Margin Analysis. It shows us how much wiggle room we have. The safety margin represents the difference between the planned volume and the break-even volume, showing us how much sales we can miss before the company starts to generate losses.
Uses in Financial Analysis
The Contribution Margin analysis is a useful way to show a product’s potential for generating profit. It gives us the portion of revenue that goes to cover fixed costs. The amount left after that is the company’s profit.
It helps us separate the fixed costs and profit coming from specific products. We use the metric to figure out the most appropriate pricing range for a product or a product line.
The Contribution Margin provides us with insight into the profit levels that can be expected from the product and is critical in structuring sales commissions policies for sales representatives and agents.
When we have products competing for the same limited production and distribution resources within the company, we can use the Contribution Margin to make a more informed decision regarding which products to push forward.
Investors and financial analysts also use the metric to evaluate the company’s dependence on its top products. If a business is too reliant on a particular star product, the introduction of a competing one can be a serious red flag.
The most significant advantage of the Contribution Margin metric is that it is easy to calculate and provides us with information on how much profit the company earns from each additional product, after hitting the break-even point. Most companies already have the necessary information; the only thing some smaller businesses have to do is classify costs as FC or VC.
Issues with the Contribution Margin
The problem with the Contribution Margin Analysis is that it only considers the CM per product. It will be much better if the calculation considers the contribution per minute instead. Some products might have a high Contribution Margin but take too much time at bottlenecks, leaving too little time for other products. We give top priority in sales and marketing to products generating the highest margin per minute.
Another issue is that regular price is usually used for the calculation, disregarding possible volume discounts. This can lead to overstated contribution margins.
A significant issue with the calculation of the Contribution Margin is that in real-life costs are not neatly divided into Fixed Costs and Variable Costs. There are much semi-variable (or quasi-variable) costs that are hard to allocate and may end up having a massive impact on the CM.
These costs may include research and development expenses, which are always subject to discussion – some managers believe them to be fixed costs, not related to the volume of production, and some think we should include them in our variable expenses.
Another example is renting machinery to support the seasonality of the business. We can argue that it is a variable cost, as it is needed to support the volume of production. On the other hand, the firm incurs it once and no longer depends on the quantities; therefore, some might perceive it as a fixed cost.
When performing a Contribution Margin Analysis, we rely heavily on the following suppositions:
- Constant selling prices, not accounting for volume discounts;
- Linear costs that we can easily divide into Fixed and Variable;
- Regular mix for multi-product companies;
- All items are produced and sold in the same period.
To illustrate how we might use the Contribution Margin within our financial analysis, we will analyze a division of a company, selling three products.
At first, when we look at the overall performance of the company we can see that in total we produced and sold 16 thousand units of our three products, for the amount of EUR 4,755 thousand. Deducting all variable costs, we arrive at a Contribution Margin of EUR 875 thousand, or 18.4%. Subtracting fixed costs gives us a profit of EUR 225 thousand or 4.7%.
Looking at it that way, we might conclude that the division’s products are performing satisfactorily.
However, less than 5% profit seems a bit low for the industry. We will, therefore, go into further detail and perform our analysis on a per-product basis.
Breaking down the numbers per product still gives us positive contribution margins for all three products. However, we immediately notice that Product B is significantly underperforming products A and C, generating only a 9% contribution margin.
Allocating the fixed costs to the three products on a per-unit basis, we already see the issue behind our overall low profitability. Product B is not profitable, generating about EUR 80 thousand losses from EUR 2,720 thousand of sales revenue.
Based on the findings from our analysis, we will introduce the issue to the management and suggest possible actions. We can try to optimize Product B’s production process to use less direct materials and overheads, or we can try to increase its selling price. Another option, although the least desireable, will be to discontinue the product altogether.
It’s a simple example, but one that accurately illustrates the benefits of Contribution Margin analysis.
By analyzing the Contribution margin and Break-even point on a per-product basis, we gather insights into the operational efficiency of the business. We can collect useful information to support our pricing policies. Once we know the profit/loss a product generates, we can analyze and adjust our pricing policy accordingly.
It is critical to have a proper, consistent approach to separating Fixed Costs and Variable Costs, which can take an immense amount of work, but at the end provides invaluable information about our profitability on a per-product basis.
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