Contribution margin analysis

Contribution margin analysis investigates the residual margin after variable expenses are subtracted from revenues. This analysis is used for comparing the amount of cash spun off by various products and services, so that management can determine which ones should be pushed at customers with enhanced marketing campaigns and commission plans. The total amount of contribution margin generated can also be compared to the total amount of fixed costs to be paid in each period, so that management can see if the current pricing and cost structure of the business is likely to generate any profits.

Contribution margin is revenues minus all variable expenses. The outcome is then divided by revenues to arrive at a percentage contribution margin. This calculation does not include any apportionment of overhead costs.

The analysis can also be used to examine the offerings of acquisition targets as part of the due diligence process, to see if an entity spins off enough cash to be worth buying. If not, those examining the entity must decide whether the price points or costs of the target entity can be altered to a sufficient extent to generate an enhanced return.

The main problem with this type of analysis is that it does not factor in the impact of products and services on the company constraint, which is the bottleneck that keeps the business from achieving higher profits. If a high contribution margin product uses an inordinate amount of constraint time, the outcome could be a reduction in the total amount of profit generated by the business. The reason is that too little time is left at the constraint to process other products. This issue can be resolved by expanding the contribution margin analysis to also encompass the use of contribution margin per minute of constraint time. Those products and services generating the highest margin per minute should have top sales priority.

A lesser concern when engaged in contribution margin analysis is that the price points included in the calculation can actually vary a great deal, depending on the use of volume discounts, special promotions, and so forth. Consequently, the revenue portion of the calculation has a tendency to be too high, resulting in excessively high estimations of expected contribution margins.

Similar Terms

Contribution margin per minute is also known as throughput per minute.

Related Courses

Financial Analysis 
The Interpretation of Financial Statements