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 below:

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 Leung Manufacturing, a small company that manufactures and sells birdbaths to specialty retailers. The birdbaths are named after recognisable Australian birds such as the Rosella and the Cockatoo.

Leung Manufacturing sells its Rosella 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 the table below to determine that on a per unit basis, their contribution margin is:

This means that for every Rosella model they sell, they will have $80 to contribute toward covering fixed costs, such as rent, insurance, and manager salaries.

But Leung Manufacturing manufactures and sells more than one model of birdbath. They also sell a Cockatoo Model for $75, and these birdbaths incur variable costs of $15 per unit. For the Cockatoo Model, their contribution margin on a per unit basis is the $75 sales price less the $15 per unit variable costs is as follows:

This demonstrates that, for every Cockatoo model they sell, they will have $60 to contribute toward covering fixed costs and, if there is any left, toward profit. Every product that a company manufactures or every service a company provides will have a unique contribution margin per unit.

In these examples, the contribution margin per unit was calculated in dollars per unit, but another way to calculate contribution margin is as a ratio (percentage).

Contribution Margin Ratio

The contribution margin ratio (CMR) is the percentage of a unit’s selling price that exceeds total unit variable costs. In other words, contribution margin is expressed as a percentage of sales price and is calculated using this formula:

For Leung Manufacturing and their ROSELLA Model, the contribution margin ratio will be

At a contribution margin ratio of 80%, approximately $0.80 of each sales dollar generated by the sale of a Rosella Model is available to cover fixed expenses and contribute to profit. The contribution margin ratio for the birdbath implies that, for every $1 generated by the sale of a Rosella Model, they have $0.80 that contributes to fixed costs and profit. Thus, 20% of each sales dollar represents the variable cost of the item and 80% of the sales dollar is margin. Just as each product or service has its own contribution margin on a per unit basis, each has a unique contribution margin ratio. Although this process is extremely useful for analysing the profitability of a single product, good, or service, managers also need to see the “big picture” and will examine contribution margin in total across all products, goods, or services.

Another example of contribution margin

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 Leung Manufacturing, if the managers want to determine how much their Rosella Model contributes to the overall profitability of the company, they can calculate total contribution margin as follows:

For the month of May, sales from the Rosella Model contributed $40,000 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 specialised 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 Leung Manufacturing are shown for the months of May and June, where fixed costs are $23,000 per month.

In May, Leung sold 500 Rosella Models at $100 per unit, which resulted in the operating income shown on the contribution margin income statement:

In June, 750 of the Rosella models were sold. When comparing the two statements, take note of what changed and what remained the same from May to June.

Using this contribution margin format makes it easy to see the impact of changing sales volume on operating income. Fixed costs remained unchanged; however, as more units are produced and sold, more of the per-unit sales price is available to contribute to the company’s net income.

Before going further, let’s note several key points about CVP and the contribution margin income statement.

• First, the contribution margin income statement is used for internal purposes and is not shared with external stakeholders.
• Secondly, in this specialised profit and loss/income statement, when net profit is shown, it actually refers to net profit without regard to income taxes. Companies can also consider taxes when performing a CVP analysis to project both pre-tax and post-tax profit, however that is beyond the scope of this introductory course on accounting.

Why use three different methods to discuss contribution margin?

Regardless of whether contribution margin is calculated on a per-unit basis, calculated as a ratio, or incorporated into an income statement, all three express how much sales revenue is available to cover fixed expenses and contribute to profit. Let’s examine how all three approaches convey the same financial performance, although represented somewhat differently.

You will recall that the per-unit contribution margin was $80 for a Leung Rosella birdbath. When Leung sold 500 units in May, each unit contributed $80 to fixed expenses and profit.

Now, let’s use June’s Contribution Margin Income Statement as previously calculated to verify the contribution margin based on the contribution margin ratio previously calculated, which was 80%, by applying this formula:

Regardless of how contribution margin is expressed, it provides critical information for managers. Understanding how each product, good, or service contributes to the business’s profitability allows managers to make decisions such as which product lines they should expand or which might be discontinued. When allocating scarce resources, the contribution margin will help them focus on those products or services with the highest margin, thereby maximising profits.

The evolution of Cost-Volume-Profit relationships

The CVP relationships of many organisations have become more complex recently because many labour-intensive jobs have been replaced by or supplemented with technology, changing both fixed and variable costs. For those organizations that are still labour-intensive, the labour costs tend to be variable costs, since at higher levels of activity there will be a demand for more labour usage. For example, assuming one worker is needed for every 50 customers per hour, we might need two workers for an average sales season, but during the Christmas season, the store might experience 250 customers per hour and thus would need five workers.

However, the growing trend in many segments of the economy is to convert labour-intensive enterprises (primarily variable costs) to operations heavily dependent on equipment or technology (primarily fixed costs). For example, in retail, many functions that were previously performed by people are now performed by machines or software, such as the self-checkout machines in stores such as Woolworths and Coles. Since machine and software costs are often depreciated or amortised, these costs tend to be the same or fixed, no matter the level of activity within a given relevant range.

In China, completely unmanned grocery stores have been created that use facial recognition for accessing the store. Patrons will shop, bag the purchased items, leave the store, and be billed based on what they put in their bags. Along with managing the purchasing process, inventory is maintained by sensors that let managers know when they need to restock an item.

In the United States, Amazon uses Amazon Go stores to offer the same service. Check out this video (copyright owned by CNET) for an example of an Amazon Go store. Note that there are currently 25 Amazon Go stores in the USA, but none in Australia or Asia.

In Australia, COVID19 accelerated the click-and-collect service offered by retailers. Customers can order online from most stores and have it ready to pick up in just a few hours (avoiding potentially long wait times for courier or postal delivery). In some instances, you don’t even need to enter the store. Woolworths offers a direct-to-boot service – order your items online and book a window to pick them up. When you arrive, click a button on the app or in the text message you received letting you know your groceries are ready – and someone will bring out your order and place it directly in your boot.

Another major innovation affecting labor costs is the development of driverless cars and trucks (primarily fixed costs), which will have a major impact on the number of taxi and truck drivers in the future (primarily variable costs). The first to be approved for use is the Nuro system in the USA (you can read more about Nuro in this article from CNET). Do these labour-saving processes change the cost structure for the company? Are variable costs decreased? What about fixed costs? Let’s look at this in more detail.

When ordering food through an app, there is no need to have an employee take the order, but someone still needs to prepare the food and package it for the customer. The variable costs associated with the wages of order takers will likely decrease, but the fixed costs associated with additional technology to allow for online ordering will likely increase. When grocery customers place their orders online, this not only requires increased fixed costs for the new technology, but it can also increase variable labor costs, as employees are needed to fill customers’ online orders. Many stores may move customer-facing positions to online order fulfillment rather than hiring additional employees. Other stores may have employees fill online grocery orders during slow or downtimes. Both Woolworths and Coles operate “dark stores” in Australia – stores that have no customers and are designed only for online order fulfilment.

Using driverless cars and trucks decreases the variable costs tied to the wages of the drivers but requires a major investment in fixed-cost assets – the autonomous vehicles – and companies would need to charge prices that allowed them to recoup their expensive investments in the technology as well as make a profit. Alternatively, companies that rely on shipping and delivery companies that use driverless technology may be faced with an increase in transportation or shipping costs (variable costs). These costs may be higher because technology is often more expensive when it is new than it will be in the future, when it is easier and more cost effective to produce and also more accessible. A good example of the change in cost of a new technological innovation over time is the personal computer, which was very expensive when it was first developed but has decreased in cost significantly since that time. The same will likely happen over time with the cost of creating and using driverless transportation.

You might wonder why a company would trade variable costs for fixed costs. One reason might be to meet company goals, such as gaining market share. Other reasons include being a leader in the use of innovation and improving efficiencies. If a company uses the latest technology, such as online ordering and delivery, this may help the company attract a new type of customer or create loyalty with longstanding customers. In addition, although fixed costs are riskier because they exist regardless of the sales level, once those fixed costs are met, profits grow. All of these new trends result in changes in the composition of fixed and variable costs for a company and it is this composition that helps determine a company’s profit.

As you will learn in future chapters, in order for businesses to remain profitable, it is important for managers to understand how to measure and manage fixed and variable costs for decision-making. In this chapter, we begin examining the relationship among sales volume, fixed costs, variable costs, and profit in decision-making. We will discuss how to use the concepts of fixed and variable costs and their relationship to profit to determine the sales needed to break even or to reach a desired profit. You will also learn how to plan for changes in selling price or costs, whether a single product, multiple products, or services are involved.