Contribution margin analysis is significant because it measures the profitability of each unit sold by the company. The contribution is a net inflow of funds to the company as additional units are sold, which is a quick method to answer questions about how various actions can affect a company’s general profitability. The contribution margin can also help a company decide on factors such as a change in price, sales volume, and fixed costs. To calculate the contribution margin, the variable expenses are subtracted from the revenue. This article will look at how contribution margin data is used in companies.
Businesses incur costs unrelated to the production and sale of a product such as rent, insurance, maintenance, and salaries. To maintain profitability, the contribution margin must cover these fixed costs as they are incurred whether the company is producing a product or not. A company can increase its contribution margin by reducing fixed costs. A higher contribution margin signifies the ability to cover fixed costs such as rent and the company’s ability to invest more in advertising to increase sales. If the company’s contribution margin does not match up to or exceed its fixed expenses, the company is operating at a loss. The contribution margin is crucial as it gives the business an idea of its profitability and what can be done to increase its profitability.
Analyzing the contribution margin helps companies decide whether to make changes to a product line, product prices, sales volume, and even sales commissions. The most common being changes to product lines. Companies can look at individual product contribution margins to determine its profitability. If a product’s contribution margin is negative, it means that the company is losing money by producing each unit of that product and has to decide whether to drop that product or increase prices to make a profit. Analyzing the contribution margin forces companies to understand their business’s cost structure.
A disadvantage of contribution margin analysis is that the assumptions made may be unrealistic. Selling prices vary depending on promotions; however, the contribution margin is calculated using one constant selling price. Secondly, costs are not always easily divided into fixed and variable costs. Lastly, manufacturers do not always sell and produce the same number of units; therefore, this would be another assumption that could affect the technique’s usefulness.
Contribution margin analysis gives businesses the ability to make assumptions about profitability. It can also guide business decisions about products, sales, and the cost structure, in general, to ascertain whether all aspects of the business are providing a return on investment. Looking at the contribution margin only will provide the business with so much and no more information. As much of the information may be considered assumptions, it is best to look at all other profit measures when making major business decisions.