MSG Team's other articles

11002 Reverse Factoring – Meaning and its Benefits

The purpose of commercial banking is to help corporations meet their funding needs in a better manner. Commercial banks help companies do this in several ways. One such way is related to the concept of reverse factoring. Reverse factoring is a solution that helps large corporations manage their supply chains better by helping optimize the […]

10286 Market Related Ratios – Meaning and Its Importance

Most investors do not invest directly in the company i.e. they are not promoters of the company. Rather they invest in the company through the stock market. This means that they buy shares at a certain value and make a profit only when the price of the shares go up or they get regular dividends […]

9247 Exorbitant Privilege: US Dollar

The financial community of the world is at a consensus that the current economic system provides the United States government with exorbitant privileges. This means that the system does not treat all countries equally. Rather it provides an unfair advantage to the United States because the dollar is the reserve currency of the world. The […]

10725 Private Equity Investments in the Sports World

Sporting franchises across the world have traditionally been owned by wealthy individuals. This has largely been because of the fact that sporting franchises have been viewed less as financially viable investments and more as vanity toys. However, all this has started changing in the wake of stellar returns provided by sporting franchises in the recent […]

11404 Advantages of Strategic Financial Management

The field of strategic financial management has become increasingly popular in the past few years. This has been because of the various advantages that accrue to the practitioners of this philosophy. In this article, we will have a closer look at some of the important advantages which result from following this philosophy. Aligns The Vision […]

Search with tags

  • No tags available.

Rearranging the Profit Equation:

The contribution margin is created by rearranging the profit equation to provide the requisite details. The profit equation is as follows: Profit = Selling Price (x) – Variable Costs (x) – Total Fixed Costs

It can be rearranged as : Profit = (Selling Price – Variable Costs)x – Total Fixed costs.

The part that has been rearranged in the bracket i.e. selling price – variable costs has become widely known as the contribution margin.

What Is The Contribution Margin?

The contribution margin as the name suggests is a contribution of every sale towards recovering the fixed costs. If we look at the equation carefully, we see that the total amount of fixed costs is the same. Thus each time we make a sale we get selling price – variable cost. This contributes towards recovering the fixed costs.

When all the fixed costs are recovered, we reach the breakeven point. Following the breakeven point, the contribution margin does not help in recovering the fixed costs, rather it contributes towards increasing the profit.

Contribution Margin Ratio:

The contribution margin can be any number, like 25 or 33 or any other for that matter. Like always in accounting, until we put this number into some context it is not very useful. Consider the case of two products, one has a selling price of $50 and a contribution margin of $15. The other has a selling price of $100 and contribution margin of $25.

Now, if we paid attention to only the contribution margin, we would think that selling the second product is more profitable. But that is not the case. For the same level of sales i.e. $100, the first product gives a contribution of $30 whereas the second gives a contribution of $25 only.

To ensure that we make the right decisions, accountants use the contribution margin ratio. This is nothing but the contribution margin divided by selling price

Contribution Margin Ratio = Contribution Margin/Selling Price = (Selling Price – Variable Costs)/Selling Price

Calculating the Contribution Margin Ratio:

Numbers can be put into the above mentioned formula to get the contribution margin ratio:

For the first product: Contribution margin ratio = $15/$50 = 30%

For the second product: Contribution margin ratio = $25/$100 = 25%

Interpreting the Contribution Margin Ratio:

The higher the contribution margin ratio, the faster the company will reach the breakeven point. Hence, companies should make an effort to sell high contribution products faster. The focus should be more but not exclusively on contribution margin ratio. This is because products with lower contribution margin sell faster and in higher volumes. Neglecting their sales completely can have adverse effects on the profitability.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Consequences of Incorrect Job Order Costing

MSG Team

Constraints and Contribution Margin Analysis

MSG Team

Allocating Overheads in Job Order Costing

MSG Team