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The contribution margin is created by rearranging the profit equation to provide the requisite details. The profit equation is as follows: Profit = Selling Price (x) – Variable Costs (x) – Total Fixed Costs
It can be rearranged as : Profit = (Selling Price – Variable Costs)x – Total Fixed costs.
The part that has been rearranged in the bracket i.e. selling price – variable costs has become widely known as the contribution margin.
The contribution margin as the name suggests is a contribution of every sale towards recovering the fixed costs. If we look at the equation carefully, we see that the total amount of fixed costs is the same. Thus each time we make a sale we get selling price – variable cost. This contributes towards recovering the fixed costs.
When all the fixed costs are recovered, we reach the breakeven point. Following the breakeven point, the contribution margin does not help in recovering the fixed costs, rather it contributes towards increasing the profit.
The contribution margin can be any number, like 25 or 33 or any other for that matter. Like always in accounting, until we put this number into some context it is not very useful. Consider the case of two products, one has a selling price of $50 and a contribution margin of $15. The other has a selling price of $100 and contribution margin of $25.
Now, if we paid attention to only the contribution margin, we would think that selling the second product is more profitable. But that is not the case. For the same level of sales i.e. $100, the first product gives a contribution of $30 whereas the second gives a contribution of $25 only.
To ensure that we make the right decisions, accountants use the contribution margin ratio. This is nothing but the contribution margin divided by selling price
Contribution Margin Ratio = Contribution Margin/Selling Price = (Selling Price – Variable Costs)/Selling Price
Numbers can be put into the above mentioned formula to get the contribution margin ratio:
For the first product: Contribution margin ratio = $15/$50 = 30%
For the second product: Contribution margin ratio = $25/$100 = 25%
The higher the contribution margin ratio, the faster the company will reach the breakeven point. Hence, companies should make an effort to sell high contribution products faster. The focus should be more but not exclusively on contribution margin ratio. This is because products with lower contribution margin sell faster and in higher volumes. Neglecting their sales completely can have adverse effects on the profitability.
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