Managers use contribution margin to analyze the profitability of products.A single product's contribution margin is given with the formula P - V, where P is the cost of the product and V is its variable cost, the costs associated with resources used to make that item, specifically.This measure may be called a product's gross operating margin.The concept of finding the amount of money a business can make from the sale of a product to pay for fixed costs is useful.
Step 1: Determine the price of the product.
The price the product is sold for is the first variable you need to find.An example problem can be found in this section.If you run a factory that makes baseballs and sells them for $3 each, then you will use the proceeds for your baseball price.
Step 2: Determine the costs associated with the product.
The only variable we need to find is the total cost of the product.The variable costs associated with a product are those that change with the number of products made.Variable costs are the costs that vary and will be greater the more products are made.The total cost of rubber and leather used to make the baseballs in the last month is assumed to be $1500.You paid your workers $2400 and your factory's utility bill was $100, for a total of $4000 in variable costs.The variable cost of each baseball is if the company produced 2000 in that month.Fixed costs do not change as production volume changes.No matter how many baseballs are produced, our company's rent will be the same.Rent is a cost.The contribution margin calculation does not include fixed costs.Building, machinery, patent applications are some of the common fixed costs.Fixed and variable costs might apply to utilities.Regardless of whether or not a single product is sold, the amount of electricity used by a store during operating hours is the same.Depending on the amount of product being manufactured, electricity may be a variable.Do you have any utilities that are in the category of variable costs?
Step 3: The variable cost is subtracted from the price.
The contribution margin can be found by subtracting the variable costs from the price.The amount of money from the sale of a single product that the company is able to use to pay fixed costs and generate profit is your answer.It is easy to find the contribution margin of a baseball.If you subtract the variable costs per ball from the price, you get 3 - 2.In real life, the contribution margin can be found on a business's income statement, a document companies publish for investors and the IRS.
Step 4: The contribution margin can be used to pay costs.
A positive contribution margin is a good thing because it helps the product recover its own variable costs and contributes to the fixed costs.Since the fixed costs don't increase with the amount of product produced, once they're paid off, the contributing margin from the remaining products sold becomes pure profit.Each baseball has a contribution margin of $1.00.1,500 baseballs need to be sold per month to make up for the fixed costs if the factory rent is $1500.Each baseball sells for $1.00 of profit after this point.
Step 5: Divide by the price to find the contribution margin ratio.
You can use the contribution margin to perform some basic financial analysis tasks.You can find the contribution margin ratio by dividing it by the price of the product.The contribution margin is the portion of each sale that is used for fixed costs and profit.The contribution margin was $1.00 and the price was $3.00.The contribution margin ratio was 1/3.It goes towards paying fixed costs and making profit.You can find the contribution margin ratio for more than one product by dividing it by the total price of the products.The contribution margin can be calculated in a ratio, in total, and per unit, depending on what analysis is most useful.You could use a total contribution margin figure to prepare the income statement.Managers can use a contribution margin income statement to better understand their companies operations.
Step 6: Break-even analysis can be done using the contribution margin.
If you know the contribution margin of a company's product, you can estimate whether the company is profitable or not.If the company isn't selling the product at a loss, all it needs to do is sell enough products to pay for its fixed costs and make a profit.The company will turn a profit if enough products are sold.Let's say our baseball company has fixed costs of $2,000, instead of the $1,500 given above.If we sell the same number of baseballs, we will make a profit.We're in this situation because this isn't enough to cover the $2,000 in fixed costs.
Step 7: The ratio and contribution margin can be used to critique a business plan.
Making decisions about the way a business is run can be helped by contribution margins.If the business isn't making a profit, this is true.You can use your contribution margin to help set new sales goals or find a way to reduce fixed or variable costs.The measure can be used to identify areas where expenses need to be cut.We've been tasked with fixing the $500 budget shortfall from the example problem.We have several options.We might try to sell 500 more baseballs since the contribution margin is $1.00.We could lower our fixed costs by moving our operations to a cheaper building.We might be able to drive down our variable costs by using more affordable materials.If we could shave $0.50 from the manufacturing of each baseball, we would make $1.50 per ball instead of $1.00, which would turn a profit.
Step 8: The contribution margin can be used to prioritize products.
If you know how profitable one item in a product line is compared with another product, you can make better decisions.If your company makes more than one product, the contribution margins can help you decide how many to make.This is important if the products use the same materials.If you must choose one product over the other, you want to choose the one with the larger contribution margin.Let's say our factory makes both footballs and baseballs.Footballs are more expensive to produce at $4 per ball but can be purchased for $8, giving a greater contribution margin.If the footballs and baseballs are made from the same type of leather, we would want to prioritize football production over baseball production.The footballs have a higher contribution margin ratio than baseballs.They are more efficient at generating revenue.