Contribution margin analysis
/What is Contribution Margin Analysis?
Contribution margin analysis investigates the residual margin after variable expenses are subtracted from revenues. This analysis is used to compare the amount of cash spun off by various products and services, so that management can determine which ones should be sold and which should be terminated. The total amount of contribution margin generated can also be compared to the total amount of fixed costs to be paid in each period, so that management can see if the current pricing and cost structure of the business is likely to generate any profits.
The analysis can also be used to examine the offerings of acquisition targets as part of the due diligence process, to see if an entity spins off enough cash to be worth buying. If not, those examining the entity must decide whether the price points or costs of the target entity can be altered to a sufficient extent to generate an enhanced return.
How to Calculate Contribution Margin
Contribution margin is revenues minus all variable expenses. The outcome is then divided by revenues to arrive at a percentage contribution margin. This calculation does not include any apportionment of overhead costs. Thus, the calculation of contribution margin is as follows:
(Revenue - Variable costs) ÷ Revenue = Contribution margin
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Example of Contribution Margin Analysis
The Iverson Drum Company sells drum sets to high schools. In the most recent period, it sold $1,000,000 of drum sets that had related variable costs of $400,000. Iverson had $660,000 of fixed costs during the period, resulting in a loss of $60,000. This information appears in the following table.
Iverson’s contribution margin is 60%, so if it wants to break even, the company needs to either reduce its fixed expenses by $60,000 or increase its sales by $100,000 (calculated as the $60,000 loss divided by the 60% contribution margin).
Problems with Contribution Margin Analysis
The main problem with contribution margin analysis is that it does not factor in the impact of products and services on the company constraint, which is the bottleneck that keeps the business from achieving higher profits. If a high contribution margin product uses an inordinate amount of constraint time, the outcome could be a reduction in the total amount of profit generated by the business. The reason is that too little time is left at the constraint to process other products. This issue can be resolved by expanding the contribution margin analysis to also encompass the use of contribution margin per minute of constraint time. Those products and services generating the highest margin per minute should have top sales priority.
A lesser concern when engaged in contribution margin analysis is that the price points included in the calculation can actually vary a great deal, depending on the use of volume discounts, special promotions, and so forth. Consequently, the revenue portion of the calculation has a tendency to be too high, resulting in excessively high estimations of expected contribution margins.
Terms Similar to Contribution Margin Analysis
Contribution margin per minute is also known as throughput per minute.