In this series, as the title implies, I will talk about the relationship between costs, unit volumes, and profitability. In this article, I will introduce the term Contribution Margin. Later in the series, I will be addressing Breakeven point, CVP Analysis, Margin of Safety & Sales Mix. Later still, I will be showing how all these budgeting and financial planning tools can be combined and utilized in Adaptive insights as an immensely powerful planning tool.
First, I will be introducing how business can benefit from understanding the Contribution Margin, not only for individual products but also by line, on total production output. Contribution Margins can be applied throughout your business, on individual products, lines, centers, subsidiaries or the entire organization should you wish.
Knowing and being able to accurately determine the contribution margin of your products and services can be immensely advantageous when making decisions, both in the short-term and in the long-term. It translates into better decision-making and will ultimately have a positive impact on the bottom line. Later in this post, I will discuss the advantages of using Contribution Margin in an income statement, as opposed to standard Gross Margin.
Understanding how products are performing in the market is critical when making decisions about a given product or product line. Should production be increased, will required investments in fixed production assets or output reduction of another product make a positive impact on the bottom line? What if different products use the same limited resources/components? Contribution Margin can tell you which products contributes most to the bottom line, and should, therefore, be favored in using the limited resource. The same if you have a production bottleneck, employee shortage etc.
The Contribution Margin is calculated by deducting Variable costs from Revenue and then dividing by revenue, like so:
Product Revenue – Product Variable Cost
Contribution Margin Diagram
Contribution Margin Income Statement
A Contribution Margin Income Statement can be said to be superior to a statement relying on a similar statement relying on Gross Margin data. However, first a few words on the differences from a normal income statement.
It varies from a normal income statement in the following three ways:
- Fixed production costs are aggregated lower in the income statement, after the Contribution Margin.
- Variable Administration and Sales expenses are grouped with variable production costs, eg. they are part of the Contribution Margin Calculation, and finally:
- The Gross Margin is replaced in the statement by the Contribution Margin.
Contribution Margin Income Statement Structure
The key difference from a normal Gross Margin Income Statement is that fixed Production costs are not included in the Contribution Margin calculation. This means that the Contribution Margin income statement is sorted based on the variability of the underlying cost information. This is particularly useful when you want to determine the proportion of expenses that truly varies directly with revenue.
This makes the Gross Margin Income Statement superior as it clearly shows the amount available to cover fixed costs and whether or not a product generates a profit or a loss. The advantage is even greater when trying to determine to what extent a line of products or a business unit is profitable.
At the end of the day, it makes it easier for management to makes decisions regarding the pricing of individual products, product lines or services, and their impact on revenues and profits. That makes it a great tool for planning, budgeting, and forecasting, as various price and production scenarios can be tested and become part of the budgeting cycle of the company. Using CPM software, such as the Adaptive Insights Suite, can enable your business to run a nearly endless amount of scenarios with high speed, accuracy, and efficiency. Enabling your business to base pricing and output, not just on a hunch, but on an informed background backed by data, benefiting your business both in the short-term and in the long run.