How Do Sales Affect Contribution Margins?
Contribution margins show the impact of a single product's sales on a company's overall profit. The sales of a product may affect contribution margins positively or negatively. A higher amount of revenue or increase in sales may not always result in a higher contribution margin, however. If expenses or returns are high, the contribution margin could stay the same or even decrease. Contribution margins are different from gross margins, because the latter reveals actual profit. In contrast, contribution margins show the percentage of actual profit a single product brought in.
The calculation of a contribution margin starts with net sales. This means the amount of revenue minus returns and allowances. Any damaged or returned product does not become a part of net sales. Allowances are discounts for high-volume customers or customers who pay invoices by a certain date. Discounts are taken from gross sales and do not count as revenue. Accountants use a company's total net sales when figuring contribution margins. If "Product A" brings in $100,000 and "Product B" brings in $200,000, net sales are $300,000
A contribution margin does not include a company's fixed costs. Any expenses that a manager cannot trace to the production of a product are usually fixed. For instance, office rent and utilities are typical fixed costs. A company incurs these costs even when production is at zero. Variable costs are directly tied to the product's production. These expenses increase or decrease when production goes up or down. A bookkeeper will subtract variable costs and expenses from net sales to get a contribution margin.
Hypothetically "Product A" has variable costs and expenses of $50,000. To get its contribution margin, you would subtract $50,000 from the company's total net sales of $300,000. This gives you a contribution margin of $250,000. If you divide the contribution margin by net sales, you get a percentage of approximately 84 percent. Let's say net sales of "Product A" increase to $150,000 and its variable costs increase to $60,000. Total net sales increase to $350,000, resulting in a new contribution margin of $290,000. The contribution margin increases by $40,000, but the percentage decreases slightly to approximately 83 percent.
It is possible that revenue of a product will decrease. Variable expenses and costs may remain stagnant if the company produces the same amount of units. "Product A's" revenue decreases to $80,000 due to a temporary decline in market share. Variable costs are still at $60,000. This decreases total net sales to $280,000 and "Product A's" contribution margin to $220,000. The contribution margin ratio or percentage also decreases to approximately 79 percent. If variable costs also decrease - say to $50,000 - the contribution margin increases by $10,000.