When is contribution margin ratio useful

One-time costs for items such as machinery are a typical example of a fixed cost, that stays the same regardless of the number of units sold , although it becomes a smaller percentage of each unit's cost as the number of units sold increases.

Other examples include services and utilities that may come at a fixed cost and do not have an impact on the number of units produced or sold. Another example of fixed cost is a website hosting provider that offers unlimited hosting space to its clients at a fixed cost. Whether the client puts one or ten websites, and whether the client uses MB or 2 GB of hosting space, the hosting cost remains the same.

In these kinds of scenarios, electricity and web-hosting cost s will not be considered in the contribution margin formula as it represents a fixed cost. Fixed monthly rents or salaries paid to administrative staff also fall in the fixed cost category. However, if the same electricity cost increases in proportion to the consumption, and the web-host charges increase on the basis of the number of sites hosted and the space consumed, then the costs will be considered as variable costs.

Similarly, wages paid to employees who are getting paid based on the number of units they manufacture or any of its variations are variable costs. Each such item will be considered for contribution margin calculations. Fixed costs are often considered as sunk costs that once spent cannot be recovered.

These cost components should not be considered while taking decisions about cost analysis or profitability measures. These three components constitute the variable cost per unit.

Such total variable cost increases in direct proportion to the number of units of the product getting manufactured. This cost of machine represents a fixed cost and not a variable cost as its charges do not increase based on the units produced. Such fixed costs are not considered in the contribution margin calculations. However, contribution margin does not account for fixed cost components and considers only the variable cost components.

The incremental profit earned for each unit sold as represented by contribution margin will be:. A key characteristic of the contribution margin is that it remains fixed on a per unit basis irrespective of the number of units manufactured or sold. The profit per unit will come to:. However, the contribution margin, which gets calculated with respect to only the variable cost, will be:. The contribution margin remains the same, even when the number of units produced and sold has doubled.

It provides another dimension to assess how much profits can be realized by scaling up sales. The contribution margin can help company management select from among several possible products that compete to use the same set of manufacturing resources.

Can you check into this and get back to me before the end of the day? She mentioned that our cost of goods sold was higher. Could there have been a price increase on one of the components of our product? Off to visit purchasing to do some research! This ratio shows the amount of money available to cover fixed costs. Measure content performance. Develop and improve products. List of Partners vendors. Accounting Basics Cost-Volume-Profit. By Rosemary Carlson.

She has consulted with many small businesses in all areas of finance. She was a university professor of finance and has written extensively in this area. Learn about our editorial policies. Your Privacy Rights. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. These choices will be signaled globally to our partners and will not affect browsing data.

We and our partners process data to: Actively scan device characteristics for identification. Knight points to a client of his that manufactures automation equipment to make airbag machines. For this client, factory costs, utility costs, equipment in production, and labor are all included in COGS, and all are fixed costs, not variable.

The most common use is to compare products and determine which to keep and which to get rid of. It requires that a managerial accountant dedicate time to carefully breaking out fixed and variable costs.

Of course, GE has a lot of resources to dedicate to this analysis. Sometimes certain salaries could be looked at this way as well. Your contribution margin could be dramatically different because of how these costs are categorized.

Another mistake that some managers make is to assume that you should cut the lowest-contribution-margin products.