Contribution margin is an important element of cost volume profit analysis that managers carry out to assess the maximum number of units that are required to be at the breakeven point. Contribution margin is the profit before fixed cost and taxes that means it covers both the FIXED costs and Profit or Loss. This is calculated under variable costing method and it is calculated as follows.
How to calculate contribution margin?
Here is the simplest formula for calculating contribution margin.
Contribution margin = Sales – Variable cost
Contribution margin ratio = Contribution / Sales
The above formulas are also known as “Contribution margin equation.” The above equation is very commonly used for breakeven analysis.
Example
If a business reports total sales of $5,000,000, $1,500,000 of fixed costs and total variable costs of $2,700,000 then as per the above formulas the relevant calculations are
Total contribution Margin= Total Sales – Total variable cost
Total contribution Margin= $5,000,000- $2,700,000
Total Contribution Margin = $2,300,000
Contribution margin ratio or CM ratio = 2,300,000/5,000,000 = 46%
It means that the variable cost represents 54% (1-46%) of the sales. It also means that the 46% consists of fixed costs and net profit portion. It also means that the 46% has to bear fixed cost yet to find out the profit before tax i.e.
Profit before tax = Total contribution – Fixed cost
= $2,300,000 – $1,500,000
= $800,000
Contribution margin Income Statement
The contribution margin income statement requires fixed and variable costs to be separately recorded. It is also called variable costing income statement. Here is the standard format of contribution margin income statement.
Sales XXX
Less: Variable Costs (XXX)
Contribution Margin XXX
Less: Fixed costs (XXX)
Profit before tax XXX
Contribution margin vs gross margin
The gross margin and contribution margin are different and report different results when used by managers.
Gross margin = (Sales – Cost of goods sold)/ Sales
This is different from variable costs as the cost of goods sold is a cost that includes both variable costs and fixed costs associated with the goods sold, whereas, contribution margin considers all sorts of variable costs in the calculation.
Detailed Example
If a business reports the following for the month of May 2016:
Sales $120,000
Direct material costs $10,500
Direct labor costs $4,600
Variable overheads $6,500
Fixed overheads $15,000
Variable selling expenses $13,000
Fixed Selling expenses $29,000
Variable admin expenses $5,000
Fixed admin expenses $22,500
Required:
Gross margin
Contribution margin and CM ratio
Prepare a contribution margin income statement.
Solution:
Gross margin = (Sales – Cost of goods sold)/ Sales
= (120,000 – 10,500 – 4,600 – 6,500 – 15,000 – 29000 – 5000)/ 120,000
= 41.25%
Contribution margin = (120,000 – 10,500 – 4,600 – 6,500 – 5000)
= $93,400
CM ratio = 93,400/120,000
= 77.83%
Contribution margin income statement
Sales 120,000
Less: Variable Costs (26,600)
Contribution Margin 93,400
Less: Fixed costs (66,500)
Profit before tax 26,900
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