6.6: Contribution Margin Analysis
A key element of the variable costing income statement is contribution margin, which is what is left over from sales after paying variable costs. In other words, contribution margin is the amount or percentage of sales available to pay fixed costs and contribute to operating income. Once fixed costs are covered, any remaining contribution margin represents profit that results from the sales.
Contribution margin may be looked at from a variety of perspectives that often involve comparisons within different segments of a company. Data may be isolated by product, geographic area, salesperson, customer, distribution method, etc. and analyzed in terms of how individuals or entities within a segment perform in terms of contribution margin percentage. Managers may use these targeted results to discover strengths that may be capitalized on and/or weaknesses that may need to be addressed.
As an example, a company manufactures two products and sells them in two regions, East and West, to two customers that have a presence in both regions. There are four salespeople in each region. Sales in these regions may be either in- store or online.
The following sales and production information will be used to show comparisons of the contribution margin for a company as a whole, by region, and by product.
|
East |
West |
Total |
|
|
Sales |
|||
|
Product 1 |
$120,000 |
$60,000 |
$180,000 |
|
Product 2 |
40,000 |
100,000 |
140,000 |
|
TOTAL |
$160,000 |
$160,000 |
$320,000 |
|
Variable manufacturing costs |
|||
|
Product 1 |
$24,000 |
$12,000 |
$36,000 |
|
Product 2 |
4,800 |
12,000 |
16,800 |
|
TOTAL |
$28,800 |
$24,000 |
$52,800 |
|
Variable selling expenses |
|||
|
Product 1 |
$50,400 |
$25,200 |
$75,600 |
|
Product 2 |
13,200 |
33,000 |
46,200 |
|
TOTAL |
$63,600 |
$58,200 |
$121,800 |
The contribution margin ratio of 45.4% for the company as a whole is determined as follows.
|
Company |
|
|
Sales |
$320,000 |
|
Variable cost of goods sold |
52,800 |
|
Manufacturing margin |
$267,200 |
|
Variable selling expenses |
121,800 |
|
Contribution margin |
$145,400 |
|
Contribution margin ratio |
45.4% |
For every $1.00 of sales, a little over $.45 remains after variable costs are covered to apply toward paying fixed costs and yielding profit. The contribution margin is $145,400, and the contribution margin ratio is 45.4% ($145,400 / $320,000). If fixed costs were $100,000, for example, operating income would be $45,400.
The analysis by product shows that the contribution margin ratio for Product 1, 38.0%, is lower that of the company as a whole, 45.4%. The ratio for Product 2 is significantly higher than both those rates at 55.0%.
|
Product 1 |
Product 2 |
|
|
Sales |
$180,000 |
$140,000 |
|
Variable cost of goods sold |
36,000 |
16,800 |
|
Manufacturing margin |
$144,000 |
$123,200 |
|
Variable selling expenses |
75,600 |
46,200 |
|
Contribution margin |
$68,400 |
$77,000 |
|
Contribution margin ratio |
38.0% |
55.0% |
Although sales of Product 2 are lower, its contribution margin ratio is 17% higher than that of Product 1. This is because the costs of producing and selling Product 2 are proportionately lower.
Based on this information, managers may look for ways to contain variable costs associated with Product 1. They also might encourage and incentivize sales staff to promote Product 2 to customers more than Product 1.
A comparison by sales region shows that the contribution margin ratio for the East, 42.3%, is lower that of the company as a whole, 45.4%. The ratio for the West is higher than both these rates at 48.6%.
|
East |
West |
|
|
Sales |
$160,000 |
$160,000 |
|
Variable cost of goods sold |
28,800 |
24,000 |
|
Manufacturing margin |
$131,200 |
$136,000 |
|
Variable selling expenses |
63,600 |
58,200 |
|
Contribution margin |
$67,600 |
$77,800 |
|
Contribution margin ratio |
42.3% |
48.6% |
At the same sales levels, the East has higher variable costs for both production and selling. Management may look at the mix of products sold in each region to determine if differences in costs in the regions are product related or if action needs to be taken to contain costs in the East.
At an even more micro level, the performance of each of the four sales people in a region may be determined. As an example, the data for sales staff in the East - Annie Adams, Charles Bell, Valerie Crew, and Scott Davis – follows.
|
Adams |
Bell |
Crew |
Davis |
|
|
Sales |
$32,000 |
$40,000 |
$51,000 |
$37,000 |
|
Variable cost of goods sold |
5,800 |
7,500 |
8,600 |
6,900 |
|
Manufacturing margin |
$26,200 |
$32,500 |
$42,400 |
$30,100 |
|
Variable selling expenses |
11,500 |
19,100 |
20,300 |
12,700 |
|
Contribution margin |
$14,700 |
$13,400 |
$22,100 |
$17,400 |
|
Contribution margin ratio |
45.9% |
33.5% |
43.3% |
47.0% |
The sales mix in terms of the percentage of each product that each salesperson sold plays a role in the variable expenses incurred and the resulting contribution margin ratio. Note that the highest contribution margin in dollars does not always result in the highest contribution margin ratio. Managers must evaluate returns on sales from both these perspectives when making decisions moving forward.
Although specific data is not provided for the following two segments – customer and distribution channel – results are presented here to show two additional types of comparisons that may be meaningful in investigating operational performance.
|
Customer 1 |
Customer 2 |
In-Store |
Online |
|||
|
Sales |
$190,000 |
$130,000 |
Sales |
$150,000 |
$170,000 |
|
|
Variable cost of goods sold |
31,700 |
21,100 |
Variable cost of goods sold |
23,700 |
29,100 |
|
|
Manufacturing margin |
$158,300 |
$108,900 |
Manufacturing margin |
$126,300 |
$140,900 |
|
|
Variable selling expenses |
75,100 |
46,700 |
Variable selling expenses |
60,100 |
61,700 |
|
|
Contribution margin |
$83,200 |
$62,200 |
Contribution margin |
$66,200 |
$79,200 |
|
|
Contribution margin ratio |
43.8% |
47.8% |
Contribution margin ratio |
44.1% |
46.6% |
Contribution margin analysis is also useful for planning purposes. For each product, sales volume, unit selling price, unit variable cost of production, and unit variable cost of selling can be forecasted to estimate contribution margin.Subsequently, one or more of these four variables may be changed to see the impact on contribution margin. The following table compares six projections based on different data. Amounts in bold font are changes from Projection 1.
|
Projection 1 |
Projection 2 |
Projection 3 |
Projection 4 |
Projection 5 |
Projection 6 |
|
|
Sales quantity |
100,000 |
120,000 |
100,000 |
100,000 |
95,000 |
110,000 |
|
Selling price per unit |
$8.00 |
$8.00 |
$8.30 |
$8.00 |
$8.00 |
$8.30 |
|
Variable production cost per unit |
2.50 |
2.50 |
2.50 |
3.00 |
2.50 |
2.75 |
|
Variable selling cost per unit |
1.75 |
1.75 |
1.75 |
1.75 |
1.40 |
1.90 |
|
Sales |
$800,000 |
$960,000 |
$830,000 |
$800,000 |
$760,000 |
$913,000 |
|
Variable cost of goods sold |
250,000 |
300,000 |
250,000 |
300,000 |
237,500 |
302,500 |
|
Manufacturing margin |
$550,000 |
$660,000 |
$580,000 |
$500,000 |
$522,500 |
$610,500 |
|
Variable selling expenses |
175,000 |
210,000 |
210,000 |
175,000 |
133,000 |
209,000 |
|
Contribution margin |
$375,000 |
$450,000 |
$405,000 |
$325,000 |
$389,500 |
$401,500 |
|
Contribution margin ratio |
46.9% |
46.9% |
48.8% |
40.6% |
51.3% |
44.0% |
Managers consider both the contribution margin dollar amount and the ratio in making decisions related to selling price and projecting quantities sold. A higher contribution margin ratio alone is favorable relative to a lower one; the 46.9% for Projection 1 is greater than the 44.0% for Projection 6. Yet if fixed costs are $375,000, the contribution margin dollar amount for Projection 1 would only be enough to break even, whereas Projection 6 would yield operating income of $26,500. Many decisions require a combination of analyses to determine the optimal outcome,but the results from separate measures can be insightful in determining points of strength and weakness.
Finally, managers may use the elements of a variable costing income statement to compare planned to actual dollar amounts and units sold.
|
Projected |
Actual |
|
|
Sales quantity |
90,000 |
110,000 |
|
Selling price per unit |
$8.50 |
$8.00 |
|
Variable production cost per unit |
2.80 |
2.70 |
|
Variable selling cost per unit |
1.60 |
1.80 |
|
Sales |
$765,000 |
$880,000 |
|
Variable cost of goods sold |
252,000 |
297,000 |
|
Manufacturing margin |
$513,000 |
$583,000 |
|
Variable selling expenses |
144,000 |
198,000 |
|
Contribution margin |
$369,000 |
$385,000 |
The actual contribution margin is $16,000 higher compared to what was projected, partially due to more unit sales than anticipated. The net decrease in unit variable cost factors in as well. Although sales revenue is higher than expected, it would be worth looking into why selling price per unit was lower than projected. It is feasible that the price concession spurred the higher sales quantity.
Variable costing may also be applicable to a service business, even though manufacturing costs are not involved. A small hotel, for example, earns revenue from renting rooms. Variable costs may include food and beverage expense forbreakfast, supplies expense, selling expense, and an incremental utilities expense amount for times when rooms are occupied. Fixed costs of rent expense for the property, salaries expense, depreciation expense, and insurance expense are typical.
The following is an example of a variable costing income statement for a hotel. The room rate is $120 per night, and 700 room nights are recorded during the month. The rate per unit for each variable cost is shown in the income statement.
|
Rooms revenue (700 x $120) |
$84,000 |
|
|
Variable costs: |
||
|
\(\ \quad \quad\)Selling expense (700 x $24) |
$16,800 |
|
|
\(\ \quad \quad\)Food and beverage expense (700 x $10) |
7,000 |
|
|
\(\ \quad \quad\)Supplies expense (700 x $8) |
5,600 |
|
|
\(\ \quad \quad\)Utilities expense (700 x $5) |
3,500 |
|
|
\(\ \quad \quad\quad \quad\)Total variable costs |
32,900 |
|
|
Contribution margin |
$51,100 |
|
|
Fixed costs: |
||
|
\(\ \quad \quad\)Rent expense |
$14,000 |
|
|
\(\ \quad \quad\)Salary expense |
12,600 |
|
|
\(\ \quad \quad\)Depreciation expense |
10,900 |
|
|
\(\ \quad \quad\)Insurance expense |
1,400 |
|
|
\(\ \quad \quad\quad \quad\)Total fixed costs |
38,900 |
|
|
Operating income |
$12,200 |
Other service businesses that would benefit from variable costing are hospitals, banks, restaurants, and airlines.