While businesses remain alert in noticing and recording the noticeable costs and profits. They miss out on a few minor yet significant costs and sums that play a great role in making them aware of their progress. One of them is the contribution margin. Let’s take a look at why they must not ignore calculating the contribution margin ratio.
Keeping track of all incoming and outgoing cash flows is crucial while running a business. However, in the rush for calculating easily identifiable amounts. The firms forget to account for sums that might not appear heavy but have a vital role to play in ensuring a business’s success. One such amount that companies often forget to consider is the contribution margin. Though the sum might not be considerable enough, given the further expenses the business requires a meeting, it does have a very important role to play in tracking its progress.
What Is the Contribution Margin?
Before diving into how this amount enables businesses to track their growth and progress. It is important to understand what it is and why it should not be overlooked. A contribution margin is the revenue amount left after firms pay for the variable business expenses. It is this remaining sum that is further utilized to cover the fixed costs. In addition, this amount could be reinvested in the business to continue the business activities without having to rely on external investment sources.
The variable costs for the firms keep changing from time to time, keeping into account the increase or decrease in the number of products to be manufactured. These expenses include the costs incurred in buying raw materials, etc. On the other hand, the fixed costs remain the same even if the number of products increases or decreases. These include costs involved in paying rent or buying machinery, etc.
As a result, businesses are prepared for the latter since the commencement of the business processes. They know the exact amount they must pay to cover those expenses. However, in the case of variable expenses, they might get surprises as the amount may change significantly. The variable cost deductions from the overall revenue are represented in the form of the contribution margin ratio as it offers a better view of the amount available to cover the fixed and operating costs involved.
How To Calculate Contribution Margin Ratio?
The contribution margin is expressed as follows:
C = R-V
CR is the Contribution Margin, R is Revenue, and V is Variable Cost
To get a clear view in terms of ratio, one can use the formula below:
CR = (R-V)/R *100
CR is the Contribution Margin Ratio, R is Revenue, and V is Variable Cost
How Does It Help A Company?
The contribution margin is indicative of the break-even points of a business. It is the most important component that helps in break-even analysis. Through this analysis, businesses get an opportunity to segregate the fixed costs from the profits that the firms have made. As a result, the firms can easily check on how much more profit they made compared to the last time.
When it comes to analyzing the break-even point, businesses can assess both the overall break-even point as well as the unit-based break-even point. For your company to separate profits made from the fixed costs incurred after paying the variable costs, you can use the below-mentioned formula:
Overall break-even point = (Total Fixed Costs)/ (Total Revenue – Variable Costs)
Unit-based break-even point = Total Fixed Costs/ Contribution Margin per unit
Reduce Recurring And Fixed Costs To A Minimum
Why Growing Businesses Should Not Overlook It?
As stated above, there are times when businesses overlook the contribution margin amount. However, it somewhere becomes a major mistake in the long run. Here are a few things that businesses can easily do and achieve if they begin accounting for their contribution margin ratio:
1. Make accurate decisions
When the costs incurred are easily detected, businesses make better decisions. Through contribution margin calculation, the firms decide whether they should have an additional product line or they should continue with whatever they are already dealing with. If they find the existing structure suitable, they continue, or else they choose the other option.
2. Consider significant reinvestments
The contribution margin lets companies tackle their fixed and operating costs and also identify the amount they are left with. This amount acts as an asset, which they utilize for reinvestment. As a result, they do not have to look for external sources of investment, which normally come from investors, who, in turn, get a share in the company and need significant returns.
3. Segregate profit components
When the fixed costs and operating costs are subtracted from the contribution margin, the profit components are identified. When the profits are assessed accurately, the businesses can compare their growth over a period effectively. Hence, the contribution margin or the ratio calculated helps businesses compare the profits of the current year with that of the previous year, thereby helping them evaluate the improvement or deterioration in their market position.
4. Determine product pricing
Based on the contribution margin figure, the businesses easily calculate the break-even points for their firm. As a result, the overall and unit-based amount can be obtained, which thereby helps them determine the product pricing to ensure their products are sold at a reasonable price in the market.
Knowing the uses of the contribution margin or its ratio makes it clear why a growing business should never overlook it. With the help of this calculation, businesses can keep a watch on their growth rate and identify if they are on the right track. In case, they identify loopholes, they can frame strategies to take care of those.
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