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:
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:
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