This article will guide the manager in understanding the effects of contribution margin to profitability and will help in formulating strategies to improve company performance.
Rallos Furniture Company has been in business for 5 years. It is engaged in producing ten kinds of house furniture. For the past years, one of its products, Elegant Aparador, had been profitable just like the other furniture. But this year, even its contribution margin is negative (variable costs of $1,000,000, deducted from sales of $900,000 equals a negative $100,000 contribution margin). Mrs. Solis, the accountant, explained to Mr. Rallos, the owner, that lately the variable costs for the said furniture (lumber and wood) increased by almost 10% but they cannot just increase the price because of some previous price commitments with clients. She further explained that if management will not be able to reduce its variable costs nor increase its price, there is nothing that management can do except to discontinue producing Elegant Aparador or find ways to improve its contribution margin ratio.
What is a Contribution Margin Ratio?
For a furniture shop like that owned by Mr. Rallos, the contribution margin is the excess of deducting variable costs (lumber, wood, and the wages of the carpenters) from the sales. It is also called gross margin. In the case of Mr. Rallos, since the contribution margin is negative, the owner is quite upset about the result and is serious about doing something about it. He is planning to take the advice of his accountant--that is, if variable costs cannot be reduced nor can prices be raised, this product might be dropped and vacant capacity will be given to another product with a positive contribution margin. Before they end the meeting, Mr. Rallos asked his accountant to compute the contribution margin ratio for further analysis.
What is the Equation for Contribution Margin Ratio?
As discussed above, contribution margin is obtained by deducting variable expenses from gross sales:
For instance, gross sales are $100,000 and variable cost is $60,000, so deducting $60,000 from $100,000, the contribution margin is $40,000.
To obtain the ratio, simply divide $40,000 over $100,000. The contribution margin is therefore 40%.
The Effect of Contribution Margin Ratio on Profitability
1. Contribution margin ratio reflects the available amount for fixed costs. Fixed costs are those costs that do not change in spite of change in sales volume and sales dollars within a specified capacity (say, 50,000 units). Some examples of these costs are rent, supervisors' salaries, depreciation, etc. If contribution margin is equal to the fixed costs, no profit is obtained. If the manager wants a 5% net profit, contribution margin must be increased also by 5%. One way of realizing this is: Assuming all other variables are constant, management can increase its selling price or reduce variable costs, whatever is applicable.
2. It will also determine the company's ability to manage its variable costs. Knowing how much is the contribution margin ratio will determine the company's budget for variable costs. If the contribution margin is too small compared to the industry, management needs to review strategies.
3. It will guide management in its pricing policies. The information on contribution margin ratio will guide management when or how to increase prices.
Conclusion - Rallos Furniture Company
After deciding to hire a consultant for the furniture design and costing , the company was able to reduce variable expenses by 10% with an increase in selling price of 10% because of its new design. They continue to produce Elegant Aparador; below is the new contribution margin statement for Elegant Aparador for the current month:
Variable Cost $900,000
Contribution margin $90,000
Contribution margin ratio 9%
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