How to Explain Contribution Margin Analysis: Examples and Limitations
What’s Up with the Copper Manufacturing Company on a Busy Business Day?
Newly hired financial analyst, Doreen Hanes, hurriedly joins Copper’s Vice Presidents with CEO Donald McHaven in a closed door conference. “We are going to launch five new products this year, gentlemen,” says Mr. McHaven. “Internet marketing will be used in promoting these products. Miss Hanes, I want you to review the techniques used by the previous analyst, Jenny Dale. Present your analysis to us during the next regular meeting. Don’t forget to consider the price and profit targets. We also have plans to increase prices before the end of this year. The new product technology that our consultant has suggested will be implemented this year. Aside from that, Miss Hanes, we are going to increase our capacity level to 100,000 units this year. I remember Miss Dale presented a simple technique called contribution margin analysis. Is that analysis still applicable in our present situation?”
“Let me include that in my report, Sir,” mutters Miss Hanes.
What is Contribution Margin? How is It Used? What is a Composite Contribution Margin?
Contribution margin is a fraction of sales that contributes to the offset of fixed costs. It is obtained by deducting the variable costs from the sales amount.
The sales amount is obtained by multiplying the total number of units sold by unit sales price. Variable costs are costs that vary with the volume of sales or production. If the amount of sales goes up, the amount of variable costs does the same. Fixed cost is the kind of cost that does not vary with sales or production. It remains constant at any level of sales or production volume.
Let us take a look at one of Copper’s products, Joey Bike:
The sales price of the Joey Bicycle is $500. The variable costs incurred in the production of one unit of Joey Bike are the following: Spare parts, $100, and assembler’s wages, $50. To compute the contribution margin, the total variable cost of $150 is deducted from the sales price of $500, which will equal $350. One product of Joey Bike can contribute $350 to the settlement of fixed costs for the period.
The contribution margin is also a good tool in determining the profit optimization of mixed products based on the assumed sales mix ratio.
This is done with the use of the composite contribution margin. By using this tool, the company can determine the number of sales or sales mix to break-even.
What is a composite contribute margin? It is the sum total of the individual products’ contribution margins.
Copper pursued its plan of launching the five new products, namely, M, N, O, P and Q. The products penetrated the market with the following contribution margin:
M $4
N $3
O $3
P $4
Q $4
Targeted Sales Mix is 2:3:3:1:2
Total Fixed Cost $38,000
How does Copper estimates the number of units to sell for each product with different contribution margins?
Answer: Copper establishes a sales mix ratio that can maximize profit. This sales mix ratio is used in obtaining the composite contribution margin by multiplying the ratio to the individual contribution margins of the products. The composite contribution margin is used to obtain the break-even sales by dividing total fixed costs by the composite contribution margin. This break-even quantity is multiplied to the sales mix ratio again to get the break-even sales units of each product.
Applying these procedures to Copper:
Product
M N O P Q
Contribution Margin Per Unit $4 $3 $3 $4 $4
mulitplied by sales mix 2 3 3 1 2
Composite Contribution Margin or $8 $9 $9 $4 $8 = $38
Contribution Margin Per Sale
Next, determine the number of sales (or mixes) to break even (also called composite units to break even). The number of sales to break even may be computed with the use of the following formula:
No. of Sales = Total Fixed Cost divided by Composite Contribution Margin
Substituting the figures in the formulas, the following is obtained:
No. of Sales = $38,000 divided by $38 equals 1,000 units
1,000 units make up the composite sales
Multiply this composite sales units, 1,000, by the sales mix ratio and obtain the following:
Product M = 1,000 units multiplied by 2 equals 2,000 units
Product N = 1,000 units multiplied by 3 equals 3,000 units
Product O = 1,000 units multiplied by 3 equals 3,000 units
Product P = 1,000 units multiplied by 1 equals 1,000 units
Product Q = 1,000 units multiplied by 2 equals 2,000 units
Please continue on Page 2 for more to explain Contribution Margin Analysis.
What are Some of the Supporting Arguments on the Contribution Margin Analysis?
The use of the contribution margin simplifies the calculation of the net income.
In a new business endeavor, the owner can easily compute the break-even point, income & sales projections, and other information for decision making. As the owner of a new business, he needs rough estimates for his financial projections. If he has the information, it will be easy for him to decide whether to add or discontinue some products, how to price certain products or services, or do some critical decisions like structuring the sales commissions or bonuses for his sales force.
In the production of multiple products, as long as the contribution margin of a certain product is positive, it is still possible to continue the production of the said product even if it obtains an accounting loss.
Contribution margin provides the information on operating leverage. Operating leverage is the measurement of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky a company’s operating income is.
What are the Limitations of Contribution Margin Analysis?
Generally, contribution margin does not assume any change in the variables; therefore, in times of unavoidable changes, this tool is not a reliable tool to use. If there is an increase in the variable cost, for instance, and the company cannot increase its sales price, the contribution margin, obviously, will be a different figure.
The use of the contribution margin assumes that the production facilities do not change. This kind of assumption connotes that the company operates on only one level of production. This analysis is misleading if the company is planning expansion or a reduction of capacity.
In a case where a variety of products with varying margins of profit are manufactured, it is also difficult to forecast the volume of sales mix which would optimize the profit with reasonable accuracy. Many factors contribute to this product mix strategy. They include technology changes, customer preferences, and competitors’ competitive advantage.
Since contribution margin is a part of the cost-volume-profit analysis, it is assumed that variable costs are variable at all levels of activity and fixed costs are fixed at all times. It is also assumed that the changes in opening and closing inventories are not significant, though sometimes they may be significant. Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore, closing stock carried over to the next financial year does not contain any component of fixed cost. If it happens, the reported net income is either understated or overstated. To avoid such discrepancy, inventory should be valued at full cost. In such a case, the contribution margin analysis is not applicable.
Any analysis pertaining to contribution margin will be correct only if input price and selling price remain fairly constant, but rarely can you can find this existing in business situations. Thus, if a cost reduction program is undertaken or the selling price is changed, the relationship between cost and profit will not be accurately depicted.
Summary of these limitations: When there are unavoidable changes in one variable–say, for instance, an increase in the variable costs and a change in components–all other variables, like the selling price, must be changed, too. This occurence is difficult and costly for management. Aside from that, other areas that are affected must be taken into consideration, like this uncertainty about customers - are the customers ready for a price increase?
Conclusion: In What Situations will the Use of Contribution Margin Analysis be Practical?
It’s easy to explain contribution margin analysis by saying that it’s practical to use in a new business. It can guide the decision maker in projecting a company’s revenue and costs. it can also help him determine the break-even point. Break-even point ascertains how many product units are required to achieve the equalization of revenue and expenses, thereby determining how many units to sell in a certain period. This kind of tool can also be used to control other areas in the company. This tool can help the decision maker in analyzing the comparision of planned and actual data. But he must be reminded that almost all data are based on assumptions that bring limitations to results. This tool does not consider changes. When assumptions can no longer be accepted, the company should use other tools that are more appropriate for the situation.
Book and Image Credits:
Management Advisory Services, Rodelio S. Roque, 1990
www.freedigitalphotos.co.uk backstreet_manchester_298798
www.freedigitalphotos.co.uk book04100016
