When assessing the financial performance of a company or business, the first reading is whether or not it has made a profit. Profit is an important figure that can point to a company’s success. But there are other elements that we should try to measure: using the contribution margin can help us to improve and understand our finances better.
To understand the importance of contribution margin, we must bear in mind that it is the measure that can determine how much money you will have left in the company after eliminating variable costs to cover fixed costs.
This metric is not usually an element that companies want to share with the outside world. It is an internal measure that can provide insight into how the business is evolving: it is important internal data that can use to make first-level decisions about the future of the company or industry.
How is the contribution margin calculated?
The contribution margin calculation is based on a very simple formula, although its application is not always so easy. The procedure tells us that we should subtract the variable costs from the net sales, from which the contribution margin is calculated.
As we can see, two determining factors are applied here, on the one hand, the net sales, and on the other hand, the variable cost.
What are net sales?
Net sales are what we call revenue. It is all the company’s money and will exclude only returns and allowances. We will see this economic data first in a balance sheet or income statement, as it is the first one generated before deducting expenses to get the final result.
What are variable costs?
Knowing variable costs is essential if a company is to have a healthy economy. However, this is a tough fight for many companies as it is not always possible to adjust a variable cost accurately.
Typically, these costs are lumped together as part of the expenses of goods or products manufactured, in conjunction with fixed prices.
Finding the variable costs will be based on all the expense items in the income statement and subtracting that amount from the net sales. But be careful; it is very important to note that a variable cost will fluctuate from month to month.
For example, if the business is a service station and the car wash increases in one month, the consumption of detergent for the washing machinery will increase. In this situation, detergent is the variable cost.
There are usually two major groups of variable costs:
- Raw materials
- Labor costs
To these two, in the case of many online shops, the shipping costs that the company itself will bear must be added.
Why be careful to differentiate between fixed and variable costs?
Because they are not the same and can confuse the statement of accounts, a fixed cost will remain relatively stable. It doesn’t matter if the company has an increasing production peak or if production decreases. The price will always be regular,
Such as the cost of rent or depreciation of the company’s premises, the basic supply costs such as telephone, the TIN king of vehicles, etc.
It is very important to note that depending on the type of company or business, these costs are not measured in the same way. Some companies may consider a fixed cost something that others will consider a variable cost. If we go back to the same example of the service station, the higher the volume of vehicle washing, the higher the water consumption. In this case, it will be a variable cost. However, for a law firm, water consumption will be more or less stable regardless of how the business is doing.
This reading makes us understand the importance of being able to analyze which are variable or fixed costs. The impact on the contribution margin is really important.
Which is better, high or low contribution margins?
For most companies, a high contribution margin is ideal. Having a high contribution margin means that you will make considerably more profit on the product concerning what it costs you to produce it.
When you increase the profit relative to the cost of production, you also increase the margin to meet fixed costs.
Many companies try to assess different levels of contribution margin expenses depending on the type of products they manufacture or services they market. Customizing the contribution margin for each product is considered useful when you want to maximize the company’s economic performance.
Of course, you should not place all the value of the analysis of the price of your products (and their profit) on the contribution margin. That is a good metric tool, but it needs other measures to optimize the company’s economics.
Not always, the economic success of a product is based on cost reduction. Sometimes a price reality check is necessary: sometimes, it is simply essential to raise the product’s price and not to change costs.
How do apply it properly?
Especially in companies of a certain size, the contribution margin may be somewhat low. Keep in mind that the contribution margin gives a numerical result in dollars. This is not always the appropriate way to determine the measures you should apply in your company.
Two formulas can be derived from the contribution margin that is somewhat more specific:
Contribution per unit
In this case, the aim is to track how a product will perform per-unit basis. The formula would be based on subtracting the variable costs from the product’s revenue and dividing it by the units sold.
This will determine the revenues of a product or a product line and the variable costs of these products. That is more complex but, at the same time, more efficient.
It can have various names, such as contribution margin ratio. For this, we have to try to find an index. By giving an index, we remove the numerical factor. We are no longer talking about dollars, we are talking about percentages.
The basic formula would be the one that divides the contribution margin per unit by the selling price per unit.
Thanks to this ratio, we can efficiently and quickly compare different products and their performance and costs.