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The contribution margin, sometimes used as a ratio, is the difference between a company’s total sales revenue and variable costs. To simply put, the contribution margin equals the amount that sales exceed variable costs. This is the sales amount that can be used to, or contributed to, pay off fixed costs. Fixed costs are production costs that remain the same as production efforts increase. Variable costs, on the other hand, increase with production levels. And, so the concept of this equation relies on the difference between fixed and variable costs. The calculation of contribution margin will help you measure how efficiently your company can produce products and maintain low levels of variable costs. It is also considered as managerial ratio because companies rarely report margins to the public. Instead, management uses this calculation to help improve internal procedures in the production process.
The contribution margin formula is calculated by subtracting total variable costs from net sales revenue.
Contribution Margin = Net Sales – Variable Costs
The two major components to calculate Contribution Margin are; Net Sales and Variable Costs. Let’s understand them separately so that this ratio calculation becomes a more simplified process for you.
Net sales are basically total sales sans any returns or allowances. This is the net amount that the company expects to receive from its total sales, which can be easily found on the income statement. While some income statements report net sales as the only sales figure, others report total sales and make deductions for returns and allowances. However, either way, this number is reported at the top of the income statement.
Variable costs are directly proportionate to the revenue and operations. As they increase, the variable costs also get impacted and see a rise. A good example of this is raw materials. As a manufacturer produces more units, it will naturally need more materials. Thus, the cost of materials varies with the level of production. As production increases, material costs increase. As production decreases, material costs decrease. Other examples of variable costs include:
Now that your concepts about net sales and variable costs are clear, let’s look an example to calculate the contribution margin.
Robin owes and runs a manufacturing plant that makes rubber pipes. In the past year, Robin had sales of INR 1,000,000 and the following variable costs:
Shipping costs: INR 1,00,000
Utilities: INR 50,000
Labor costs INR 4,00,000
Production supplies: INR 3,00,000
Here’s how to calculate his company’s contribution margin.
Contribution Margin= 1,000,000 – 8,50,000 = INR 1,50,000
As you can see, Robin has a Contribution Margin of INR 1,50,000. This means that he has INR 1,50,000 to put toward his fixed costs. The remainder of the margin after the fixed costs have been paid off is company profit. So, let’s assume that Robin’s fixed costs include the following:
Rent: INR 50,000
Insurance: INR 35,000
Property Taxes: INR 20,000
Robin's total fixed costs equal INR 1,05,000. This means that the production of rubber pipes is ample enough revenue to cover the fixed costs and still leave Robin with a profit of INR 45,000 at the end of the year.
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