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Measuring break-even and profitability levels is a challenge that managers face. These figures can be difficult to calculate, especially when there is a wide range of products to consider. Fortunately, there are well established methods and techniques for getting the job done; one such method is to calculate and apply the contribution margin and the contribution margin ratio figures. While the method is simple enough to use, it also has a major disadvantage or pitfall.
The contribution margin determines how much of each sales dollar goes toward paying fixed expenses and contributing to making a profit. It is calculated using this formula:
Contribution margin = sales – variable costs
The contribution margin ratio goes one step further by calculating contribution margin as a percentage of sales. This makes it possible to determine the break-even point and the additional units of sales that are required to make a predetermined profit target. The contribution margin ratio is calculated using this formula:
Margin contribution ratio = (Contribution Margin / Sales) × 100
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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:
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.
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Contribution margin is a great tool for determining break-even levels and profit targets, but when it is used without consideration for the effect that a significant fall or rise in the production or sales levels could have, any analysis based on those calculations will be rendered inaccurate. Increased sales or production levels often require additional investments or expenditure in new machinery, storage capacity, and sales support; ignoring these realities can render the use of the ratio woefully misleading.
So while using contribution margin analysis can be used to quickly determine the profitability of various products, the disadvantage of using this type of analysis is that it makes big assumptions that can throw off the validity of the analysis, particularly where fixed expenses become fluid.
“Advantages and disadvantages of contribution margin analysis." Flickr/bgilliard