The difference between a company’s total sales revenue and variable costs is also known as a contribution margin. Sometimes used as a ratio, it shows the amount that the variable costs are exceeded by sales. The result is a sales amount that can help to pay off fixed costs – either entirely or just as a contribution to this.
Contribution margin is basically the difference that comes as a result of the comparison of fixed and variable costs. While variable costs increase at the same time with the production levels, the fixed costs are the production costs that don’t change their value, even if the efforts of the production increase.
The Basics of Contribution Margin
Also considered a managerial ratio, the contribution margin is used to measure the way in which a company can produce products and also maintain a low level of variable costs – efficiently or inefficiently.
However, even though we mentioned it is seen as a managerial ratio, it is not reported to the public. Instead, it helps the management team to contribute to the improvement of the internal procedures in the production process.
The Formula of Contribution Margin
In order to find the contribution margin, you have to do a very simple calculus – namely, you only have to subtract the total variable costs from the net sales revenue. Let’s look a bit at what each of these means.
The net sales represent the total sales of a company, minus allowances or returns – basically, the net amount that is expected to be received from the total sales of a company.
The number of total sales can be found at the top of the income statement, and it usually includes the net sales as the sales figure, but there are some companies that report them while also deducting allowances and returns.
On the other hand, variable costs represent the expenses which, as the operations or revenue increase, also increase proportionately. In short, the cost of materials, for example, is dependent on the level of production. For example, rent is a fixed cost, as it does not increase with the level of production – while labor costs may increase if it is required.
The contribution margin is mainly used when the management team has to set the price of a product. This metric will give them insight as to how much they can charge for a certain item, taking into account the growth of production and the fact that the scale continues, as well.
Moreover, it helps them determine which operations and products are actually profitable – basically, the contribution margin will help the management decide which branches need to be stopped or shut down.
But this formula can also aid them with the prediction of the success of certain pricing models – they will know beforehand if a price will be profitable for them or not. In the end, the contribution margin shows how fast and how efficient a company can make a profit.
Furthermore, the equation can help them come up with something we call the forecasted profit of the company – the prediction of profit if a product is going to be sold at a certain price.