1. Definition: What is the contribution margin?
Contribution margin – what is it? In cost and performance accounting (KLR), the contribution margin (DB) denotes the difference between the revenues and the variable costs. It indicates how much a certain product contributes to covering fixed costs and can, for example, be used to calculate the sales volume from which the company will make a profit (break-even point). The contribution margin accounting is therefore a partial cost accounting which, in contrast to the full cost accounting, does not offset the complete costs but initially only the variable costs on the cost units.
Fixed costs are the fixed costs of the total costs and remain constant for a certain period of time. For example: license fees, rental expenses, administrative costs, etc.
In principle, coverage amounts can relate to two elements:
- A single product (unit contribution margin) or
- The total sales volume (total contribution margin)
- Special case: Relative contribution margin.
According to gradphysics.com, the piece contribution margin can be calculated for a piece or a unit. To determine the unit contribution margin, the variable costs per unit are subtracted from the sales revenue per unit. If the result is above zero, it is a positive contribution margin. It is common for there to be a positive contribution margin. A negative DB is when the value of sales revenue per item minus variable costs per item is less than zero. The company loses with every piece sold, it has to record losses. If the contribution margin is negative, the corresponding products are removed from the range. In some cases, however, the products with a negative contribution margin are still being manufactured, as it is important to round off the range. That is the case then if many other products are characterized by a positive contribution margin. To determine the total contribution margin, the unit contribution margin is multiplied by the sales quantity. The relative contribution margin is a special case.
Importance of the relative contribution margin
The relative contribution margin is the ratio of the unit contribution margin to a bottleneck factor. It is always calculated when there are bottlenecks in a company. The relative contribution margin can determine the optimal production program with limited capacities; it is primarily about limited machine capacities. But even if qualified staff is scarce due to illness or bad planning during the holiday season, the relative contribution margin can be useful. It can be calculated by dividing the unit contribution margin by the bottleneck utilization per unit.
2. Calculation of contribution margins / cost accounting
How to calculate the contribution margin? The contribution margin is calculated in cost accounting by deducting the variable costs from the revenue. It is part of the contribution margin calculation and the break-even analysis and is the amount that is available to cover the fixed costs. The contribution margin calculation is used to determine the success of a company and is used in the offer calculation for the formation of prices.
- Unit contribution margin = unit price – variable unit costs
- Total contribution margin = total revenue – total variable costs
- Relative contribution margin = piece contribution margin: time of bottleneck utilization per piece (e.g. production time as bottleneck factor)
Contribution margins can be determined either in a simple contribution margin calculation or in a multi-level contribution margin calculation.
Simple contribution margin calculation
With the simple DB calculation, all variable costs of the cost centers under consideration are deducted from the sales revenues and the individual contribution margins of each cost center are determined. All fixed costs are then deducted from the contribution margin. If the contribution margins are greater than the fixed costs, the company makes a profit across all products and services.
A sausage stand sells 4,000 red sausages per month for € 2 each. The purchase price per sausage is € 1. The rental of the stand and the costs for two employees total € 1400.
- Unit contribution margin = € 2 (unit price) – € 1 (variable unit costs)
The unit contribution margin is € 1, which means that each sausage sold contributes one euro to the rent and the employees.
- Total contribution margin = 8000 € (total revenue 4000 pieces * 2 €) – 4000 € (total variable costs 4000 pieces * 1 €)
The total contribution margin is 4000 €.
Multi-level contribution margin calculation
With the multi-level calculation, the fixed costs are first divided into individual areas. The reason for this is the increasing amount of fixed costs due to large investments. The areas can be divided into product-fixed costs that can be assigned directly to the product, area-fixed or product group-fixed costs that can be assigned to a company area or a product group, and general fixed costs or company fixed costs that cannot be assigned to either of the two. The multi-level contribution margin calculation allows more detailed insights and, at the same time, better decisions.
Breakdown of fixed costs into:
- Product Fixed Costs – Fixed costs that can be assigned to a specific product type.
- Product group fixed costs – Fixed costs that cannot be assigned to the product or product type, but only to a higher-level product group.
- Company Fixed Costs – The remaining fixed costs that cannot be allocated to any of the other areas
The sausage stand no longer only offers red sausages, but also currywurst and crêpes. In order to be able to offer crêpes, a specialist had to be hired who was only responsible for this.
The following fixed costs are incurred:
- Personnel costs: € 2,900
- Rental costs: 1000 €
- Other costs (insurance, etc.): € 500
The personnel costs are divided between a mini jobber in the red sausage sales and in the currywurst and a permanent employee who is responsible for crepes. These are therefore product fix costs.
The multi-level contribution margin can be expanded by several levels. For example, the product group fixed costs / area-fixed costs.
The profit margin for four products is calculated in the following video:
3. Thought of the contribution margin
Why is the contribution margin important? The determination of contribution margins is necessary in order to determine the prices for the products. The sales price must at least cover the variable costs of a product. Amounts that exceed the variable costs can be used to cover the fixed costs. The contribution that is used to cover the fixed costs is the contribution margin. If the contribution margin exceeds the fixed costs, a profit is made with the product or with all products of a company.
In addition, the findings from the contribution margin calculation are very helpful for many decisions:
- Which product or product group should the company focus on?
- Which products are uneconomical?
- Which production process is optimal for the company?
- What is the company’s lower price limit?
4. Break-Even Point – Will I Make a Profit?
The contribution margin is an important tool for determining the break-even point. The break-even point is the point at which costs and revenues are on the same level. If the break-even point is not reached, losses are recorded. If the break-even point is exceeded, profits are made. The contribution margin can be used to determine the products that make profit contributions. If the contribution margin per product is determined, the entrepreneur receives precise information about which products make a high contribution to covering fixed costs and which products are not involved in covering fixed costs at all. The contribution margin calculation provides information on whether sales promotion measures need to be taken or whether products should be removed from the range.
5. The contribution margin as an entrepreneurial parameter
The contribution margin is an important business parameter and a decisive tool for optimal price calculation . In order for the production of a product to pay off, it is important that this product makes at least a contribution to covering fixed costs and ideally also contributes to the generation of a profit. If this is not the case, the entrepreneur records a loss and should remove the corresponding product from the range.
This parameter is one of the most important business tools when it comes to adapting and optimizing your own product portfolio. The contribution margin is part of the cost and performance accounting, it can be calculated on an individual product or on the entirety of the products. The break-even point can be determined with the contribution margin. This is where a company starts to make a profit. For start-ups in particular, breaking even is an almost vital date.
Statement of the contribution margin
The contribution margin calculation is well suited to determine the amount for individual products or for certain product groups that they contribute to the operating result . In addition, the contribution margin provides information on the cost structure in the company and its structure. The aim of the contribution margin calculation for companies is therefore to compare the product revenues with the specific costs of manufacturing the product. Thus, the contribution margin is the difference between the revenue generated with a product or service and the variable costs that are directly related to it.