A company's marginal income is the difference between the amount of income the company generates and the amount of variable costs it incurs. Variable costs are often associated with the means of production, such as raw materials and energy expenditures. The marginal income, also known as contribution margin, shows how much these costs affect the company's profit potential, as the company must use its marginal income to cover its fixed costs, such as employee wages, equipment maintenance and property mortgages or rentals.
The primary factors in calculating marginal income are total sales and total variable costs. Companies can measure these factors either by each business unit or on a companywide basis. For instance, an automaker wants to determine its marginal income for different business units. The automaker sells luxury sedans and sport utility vehicles. The price of a luxury sedan is $75,000 and the variable costs per unit are $50,000. The price of an SUV is $50,000 and the variable costs per unit are $15,000.
The marginal income for each unit is defined as the difference between the unit price and the variable costs per unit. In the example above, the marginal income for the automaker's luxury sedan is (75,000-50,000), or $25,000. The marginal income for the SUV is (50,000-15,000), or $35,000. Although the luxury sedan brings in more revenue, the SUV has a higher marginal income due to its lower variable costs.
Accountants use the marginal income to calculate the percentage of sales required to pay the variable costs. This percentage is also called the contribution margin ratio. The contribution margin, or CM, ratio is the ratio between the marginal income and total sales. In the example above, the CM ratio for the luxury sedan is ($25,000/$75,000), or 0.33. The CM ratio for the SUV is ($35,000/$50,000) or 0.7. The higher CM ratio for the SUV means that each SUV sale contributes more toward paying off its variable costs than each sale of the luxury sedan toward its variable costs.
Managers use the marginal income as part of their break-even analysis. A break-even analysis shows how many units a company must sell to cover its fixed and variable costs. Any sales below that point will cause the company to lose money, while any sales beyond that point will contribute to the company's profits. The break-even point is the ratio between the company's fixed expenses and its marginal income.
From the example above, the automaker has $1,000,000 per week in fixed expenses at its luxury sedan plant. The break-even point for luxury sedans is:
1,000,000/25,000 = 40 luxury sedans/week.
The automaker has $1,500,000 per week in fixed expenses at its SUV plant. The break-even point for SUVs is:
1,5000,000/35,000 = 42.85 SUVs/week.