Principles of Accounting, Volume 2: Managerial Accounting

# 3.1Explain Contribution Margin and Calculate Contribution Margin per Unit, Contribution Margin Ratio, and Total Contribution Margin

Principles of Accounting, Volume 2: Managerial Accounting3.1 Explain Contribution Margin and Calculate Contribution Margin per Unit, Contribution Margin Ratio, and Total Contribution Margin

Before examining contribution margins, let’s review some key concepts: fixed costs, relevant range, variable costs, and contribution margin. Fixed costs are those costs that will not change within a given range of production. For example, in the current case, the fixed costs will be the student sales fee of $100. No matter how many shirts the club produces within the relevant range, the fee will be locked in at$100. The relevant range is the anticipated production activity level. Fixed costs remain constant within a relevant range. If production levels exceed expectations, then additional fixed costs will be required.

For example, assume that the students are going to lease vans from their university’s motor pool to drive to their conference. A university van will hold eight passengers, at a cost of $200 per van. If they send one to eight participants, the fixed cost for the van would be$200. If they send nine to sixteen students, the fixed cost would be $400 because they will need two vans. We would consider the relevant range to be between one and eight passengers, and the fixed cost in this range would be$200. If they exceed the initial relevant range, the fixed costs would increase to $400 for nine to sixteen passengers. Variable costs are those costs that vary per unit of production. Direct materials are often typical variable costs, because you normally use more direct materials when you produce more items. In our example, if the students sold 100 shirts, assuming an individual variable cost per shirt of$10, the total variable costs would be $1,000 (100 ×$10). If they sold 250 shirts, again assuming an individual variable cost per shirt of $10, then the total variable costs would$2,500 (250 × $10). Contribution margin is the amount by which a product’s selling price exceeds its total variable cost per unit. This difference between the sales price and the per unit variable cost is called the contribution margin because it is the per unit contribution toward covering the fixed costs. It typically is calculated by comparing the sales revenue generated by the sale of one item versus the variable cost of the item: In our example, the sales revenue from one shirt is$15 and the variable cost of one shirt is $10, so the individual contribution margin is$5. This $5 contribution margin is assumed to first cover fixed costs first and then realized as profit. As you will see, it is not just small operations, such as the accounting club scenario provided in Why It Matters, that benefit from cost-volume-profit (CVP) analysis. At some point, all businesses find themselves asking the same basic questions: How many units must be sold in order to reach a desired income level? How much will each unit cost? How much of the sales price from each unit will help cover our fixed costs? For example, Starbucks faces these same questions every day, only on a larger scale. When they introduce new menu items, such as seasonal specialty drinks, they must determine the fixed and variable costs associated with each item. Adding menu items may not only increase their fixed costs in the short run (via advertising and promotions) but will bring new variable costs. Starbucks needs to price these drinks in a way that covers the variable costs per unit and additional fixed costs and contributes to overall net income. Regardless of how large or small the enterprise, understanding how fixed costs, variable costs, and volume are related to income is vital for sound decision-making. Figure 3.2 Starbucks. Large corporations like Starbucks use cost-volume-profit analysis to make decisions about their products and services to ensure that they are maximizing their revenues. (credit: modification of “StarbucksVaughanMills” by “Raysonho”/Wikimedia Commons, CC0) Understanding how to use fixed costs, variable costs, and sales in CVP analyses requires an understanding of the term margin. You may have heard that restaurants and grocery stores have very low margins, while jewelry stores and furniture stores have very high margins. What does “margin” mean? In the broadest terms, margin is the difference between a product or service's selling price and its cost of production. Recall the accounting club’s T-shirt sale. The difference between the sales price per T-shirt and the purchase price of the T-shirts was the accounting club’s margin: Recall that Building Blocks of Managerial Accounting explained the characteristics of fixed and variable costs and introduced the basics of cost behavior. Let’s now apply these behaviors to the concept of contribution margin. The company will use this “margin” to cover fixed expenses and hopefully to provide a profit. Let’s begin by examining contribution margin on a per unit basis. ### Unit Contribution Margin When the contribution margin is calculated on a per unit basis, it is referred to as the contribution margin per unit or unit contribution margin. You can find the contribution margin per unit using the equation shown in Figure 3.2. It is important to note that this unit contribution margin can be calculated either in dollars or as a percentage. To demonstrate this principle, let’s consider the costs and revenues of Hicks Manufacturing, a small company that manufactures and sells birdbaths to specialty retailers. Hicks Manufacturing sells its Blue Jay Model for$100 and incurs variable costs of $20 per unit. In order to calculate their per unit contribution margin, we use the formula in Figure 3.2 to determine that on a per unit basis, their contribution margin is: This means that for every Blue Jay model they sell, they will have$80 to contribute toward covering fixed costs, such as rent, insurance, and manager salaries. But Hicks Manufacturing manufactures and sells more than one model of birdbath. They also sell a Cardinal Model for $75, and these birdbaths incur variable costs of$15 per unit. For the Cardinal Model, their contribution margin on a per unit basis is the $75 sales price less the$15 per unit variable costs is as follows: You rent a kiosk in the mall for $300 a month and use it to sell T-shirts with college logos from colleges and universities all over the world. You sell each T-shirt for$25, and your cost for each shirt is $15. You also pay your sales person a commission of$0.50 per T-shirt sold in addition to a salary of $400 per month. Construct a contribution margin income statement for two different months: in one month, assume 100 T-shirts are sold, and in the other, assume 200 T-shirts are sold. Solution ### Total Contribution Margin This “big picture” is gained by calculating total contribution margin—the total amount by which total sales exceed total variable costs. We calculate total contribution margin by multiplying per unit contribution margin by sales volume or number of units sold. This approach allows managers to determine how much profit a company is making before paying its fixed expenses. For Hicks Manufacturing, if the managers want to determine how much their Blue Jay Model contributes to the overall profitability of the company, they can calculate total contribution margin as follows: For the month of April, sales from the Blue Jay Model contributed$36,000 toward fixed costs. Looking at contribution margin in total allows managers to evaluate whether a particular product is profitable and how the sales revenue from that product contributes to the overall profitability of the company. In fact, we can create a specialized income statement called a contribution margin income statement to determine how changes in sales volume impact the bottom line.

To illustrate how this form of income statement can be used, contribution margin income statements for Hicks Manufacturing are shown for the months of April and May.