What is contribution margin?

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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