Contribution Margin: a key concept

In our previous article, Breakeven Analysis: From Loss to Profit, we discussed the basics of how to calculate a breakeven point using cups of coffee sold in a coffee cart business, as our example.  An extension of this concept is Contribution Margin (CM) Analysis. Understanding the CM of a product or service we sell, will tell us how much of our revenue is actually going toward covering our fixed costs.  Referring back to our coffee stand example in the aforementioned article, if we sell a cup of coffee for $2.00, and our fixed costs per month are $250, and our variable cost per cup is $0.28, then each cup we sell contributes $1.72 to covering our $250 of monthly fixed costs.  How did we calculate this, and why is this information useful?

The formula for calculating Contribution Margin is as follows:

Contribution Margin = Unit Revenue – Unit Variable Cost

where,

Unit Revenue = the price at which you sell one unit of your product/service

Unit Variable Cost = the variable costs for a single unit of your product/service.

Applying our pricing and cost data from the coffee cart example to this formula shows us how we arrived at a per cup Contribution Margin of $1.72 (which equals $2.00 – $0.28).

By dividing the Contribution Margin of $1.72 by the Unit Revenue of $2.00, we arrive at the Contribution Margin Ratio.

Contribution Margin Ratio (CMR) = $1.72 ÷ $2.00 = 0.86 = 86%

What this ratio is telling us is that 86% of our revenue is being used to reduce our fixed costs.  Knowing this becomes useful when we start to consider the impact of several typical scenarios or changes to our simple coffee cart business example.

Scenarios:

  1.  What if we get a price break on the items we need to sell our coffee (e.g., our supplier of cups decides to give us a discount)?  If I decide to keep this savings to myself (rather than passing the savings on to the customer by reducing our price) what’s the impact going to be?  Conversely, if I do decide to pass the savings on to the customer by reducing our sale price, how much should I reduce the price by to maintain the same contribution margin ratio?
  2. What if I decide to employ another person to help when I’m not there?  Should I offer any kind of a bonus or commission to the compensation structure?  If so, what will the impact be to my ability to cover my fixed costs?
  3. What if I want to expand my product line and start selling macaroons with my coffee (because they’re delicious)?  How should I price this new product, and what will the impact then be on my contribution margin ratio?  If I don’t like the impact this new product will have, can I reduce any of its variable costs?

By ‘modeling’ the different scenarios above, regarding supplier discounts, sales & promotions, salary & commission, and product line expansion, we can determine the impact on our ability to cover our fixed costs.

Contribution Margin Ratios help us to understand what our operating leverage is, that is to say it helps us to understand how our sales impact our profits (or how our sales growth contributes to our profit growth).  Typically, we would expect to see high Contribution Margin Ratios in businesses that are capital intensive, and we’d expect to see low CMRs in businesses that are more labor intensive.  This makes sense when you consider the formula.  Lastly, it can help a business owner optimize their pricing and overall cost structure when considering changes to their business.

Contribution Margins and Breakeven Points are fundamental concepts taught in the field of Management Accounting (aka: Cost Accounting).  Hopefully, this article helps you to better understand how cost, volume, and profit are related.  Please feel free to reply with a comment or question and we’ll do our best to address it.

 

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