Different types of indicators help business people and business analysts make crucial decisions. For example, they can decide on the number of products produced and the cost reduction. So, the business people can evaluate many Key Performance Indicators (KPIs) to make intelligent decisions, ultimately helping their business grow.
The profit alone cannot provide you with enough information about your business as it does not inform you about your sales policy and costing strategy loopholes. For this, you need to look at various figures and ratios. For example, contribution margin is a figure that reflects a company’s financial position.
If you have started your business and have no idea if your business is on the right track and what strategies are best to grow your revenues, then contribution margin can help you.
This blog will discuss what a profit margin is and how you can calculate it. Moreover, we will explain why this KPI of contribution is so important to track while making predictions about your business growth potential. Before that, let us explain a break-even point and how business people calculate it? So, let’s dive into this critical number of contribution margin!
What Is a Break-Even Point?
A break-even point indicates a point where a business is making neither profits nor losses. It means that the revenues and costs are equal to each other, and the company is in a position to cover its costs only – both fixed and variable costs.
Fixed costs are expenditures that do not change and remain identical regardless of production level. For example, the company has to pay rent, interest, and insurance and does not change with increased production.
On the other hand, the variable costs correlate with the production level, and as the production increases, the variable cost also increases. On the contrary, the lower production level reduces the variable cost also. For example, the salaries paid to the employees increase with increased sales and production.
The break-even point helps a business develop useful projections on the number of products. The break-even point tells how many products should be produced to earn profit by increasing revenues and reducing costs.
How to Calculate a Break-even Point?
The formula of a break-even point is straightforward, and you need to know only fixed, cost, variable cost, and total revenue.
Break-even Point = Fixed Cost/Contribution Margin
Break-even Point = Fixed Cost/(Sales Revenue – Variable Cost)
What Is a Contribution Margin?
The contribution margin is a figure that tells about a company’s financial position in the form of a break-even point. As the break-even point includes fixed and variable costs, the contribution margin calculates only the variable costs.
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How to Calculate Contribution Margin?
You need to know about the sales revenue and variable cost to calculate the important margin. For this, subtract the variable cost from sales revenue, and you will get a figure. This figure is known as the contribution margin.
Contribution margin = Sales Revenue – Variable Cost
On the other hand, contribution margin can be expressed as a ratio or percentage. When we calculate contribution margin as a percentage of total revenue, the contribution margin ratio is the resulting number.
Contribution margin ratio = (Sales Revenue – Variable Cost )/Sales Revenue
Why Is the Contribution Margin Ratio Important?
The contribution margin ratio or figure identifies the break-even point as discussed earlier. In other words, this KPI determines how much sales the owner should increase to attain a certain profit level. Moreover, it gives information about the price changes required to achieve specific profit goals.
1. Productive Use of Resources
When a firm is producing various products, it calculates the contribution margin of each type of product. It helps the businesses to pinpoint the area where the production of a product is negatively affecting the profit. For example, a company will cut back the production output with a negative margin value. So, this vital figure identifies the leakages in the production process and helps businesses use their resources efficiently.
2. Smart Decisions
Secondly, the companies can use this critical margin as a guide to change their cost structure or production line. A positive margin will help scale up the production of a product. On the other hand, a lower or negative ratio will lead the financial analysts to cut costs by reducing the production level.
3. Understand Cost Structure
Thirdly, the important ratio instantly helps a company understand the cost structure. You can analyse the fixed costs and the variable costs. As a result, you can decide which cost to reduce to increase the profits or sales revenue.
4. Financial Performance
Last but not least, this crucial margin indicates the actual financial performance of a business, and a higher or positive number means the company is on the right track. Moreover, the owner can change the strategy by altering the cost structure or prices of the products to attain higher sales revenue and profits. Furthermore, it is used to calculate the break-even point where a company only covers its total costs.
Let’s Sum Up!
In sum, contribution margin is an essential financial indicator to analyse the financial health and performance of a business. If a company has a higher margin, it can increase its sales revenue by increasing the production level. Moreover, this ratio also helps calculate the break-even point of a business.
Besides, you can understand the cost structure and profit strategies with the help of this figure. This essential margin is used in making financial and business decisions to project future sales and profits. So, this indicator of contribution margin cannot be overlooked at all while you want to develop your business competitively.
Disclaimer: All information contained in this blog is only for educational and general purposes.