Advantages and Disadvantages of Contribution Margin Analysis
To better understand how this ratio is used we will look at an example. Let us assume that XYZ has realized the following sales and expense figures:
Sales (1,000 units @ $20) $20,000
Variable expenses $7,000
Fixed Expenses $2,000
First we will need to calculate the contribution margin.
Contribution margin = Sales – Variable expenses
= $20,000 – $7,000
We can now calculate the contribution margin ratio.
contribution margin ratio = (contribution margin / sales) × 100
= ($13,000/$20,000) x 100
A contribution margin ratio of 65% tell us that for every dollar of sales just over 65% goes toward paying for fixed expenses and contributing to net profits. One can be forgiven for thinking that net profits will continue to increase in the same proportion to sales and variable costs even while sales continue to rise to higher levels, but that assumption would be wrong.
While fixed expenses generally remain constant, they don’t remain that way indefinitely. In fact, in order to increase sales it may be necessary to ramp up production capacity, which could also cause the so-called fixed expenses to vary. In other words, fixed expenses generally remain fixed while operations remain relatively confined.
Herein lies the problem with applying a simplistic interpretation to the contribution margin figure. Because the figure is calculated based on the assumption that fixed expenses will remain constant, any move in fixed expenses could render an analysis using that figure completely misleading and false.