Business economics
Revenue, costs and margins
Separate fixed from variable costs, calculate contribution, and see how it differs from gross margin.
Learning objectives
- Separate fixed and variable costs
- Calculate contribution per unit and the contribution margin ratio
- Distinguish contribution margin from gross and operating margin, and use contribution to judge a decision
The income statement groups costs by function: cost of goods sold, selling, admin. Managers deciding what to price, what to sell and whether to take an order need a different split: by how costs behave as volume changes.
That split explains why some businesses become very profitable once they pass a certain size, why airlines fight for the last seat, and why a full-cost-per-unit figure can lead you to turn down profitable work.
Fixed and variable costs
- Variable costs rise and fall with each unit sold: coffee beans, cups, card-payment fees, sales commission.
- Fixed costs stay the same over a range of volume: rent, salaried staff, insurance, depreciation.
What each unit leaves after its own variable costs is its contribution: it contributes first to covering fixed costs, then to profit.
Contribution per unit = Price − Variable cost per unit CM ratio = Contribution ÷ Price Operating profit = Units × Contribution per unit − Fixed costs
- CM ratio
- contribution margin ratio: the share of each riyal of sales left after variable costs
Putting contribution to work. Because fixed costs don't move, every extra cup adds its full contribution to profit. If the café sells 10% more cups, profit rises from 16,500 to 22,350, an increase of 35.5% from a 10% rise in volume. The CM ratio gives the same answer in riyals: each extra riyal of sales adds about 65 halalas of profit. That is how a manager quickly sizes a promotion, a new opening hour or a price change.
The limits. "Fixed" only holds within a range. Sell far more cups and the café needs a second machine or another barista, a step in fixed costs. Some costs are mixed, such as a phone plan with a base fee plus usage, and must be split into their fixed and variable parts before the arithmetic works.
Contribution margin vs gross margin
They sound alike but answer different questions.
- Gross margin (from the income statement) deducts cost of goods sold. COGS can include fixed production costs such as factory rent and depreciation, and it excludes variable selling costs such as sales commission.
- Contribution margin deducts all variable costs, wherever they sit in the income statement, and no fixed costs.
Use gross margin to compare product profitability as reported; use contribution margin to predict how profit responds to volume.
Calculate
A product sells for 250 and has variable costs of 160 per unit. What is its contribution margin ratio?
Check your understanding
Your factory has spare capacity. Its full cost is 40 per unit: 25 variable plus 15 of fixed overheads allocated per unit. A new customer offers 32 per unit for a one-off order that won't affect your other sales or your fixed costs. On the numbers alone, should you accept?
Challenge: contribution vs gross margin for one product
A fictional maker of office chairs. Build the contribution view (rows 10–14) and the accounting view (rows 17–19). Sales commission is a variable selling cost, so it is not in COGS. Fixed production overhead is in COGS but is not a variable cost. Link everything to the assumptions.
| A | B | |
|---|---|---|
| 1 | Assumptions | |
| 2 | Units sold | 12,000 |
| 3 | Price per unit | 85.00 |
| 4 | Variable production cost per unit | 38.00 |
| 5 | Sales commission per unit | 5.00 |
| 6 | Fixed production overhead | 180,000 |
| 7 | Fixed selling & admin costs | 210,000 |
| 8 | ||
| 9 | Contribution view | SAR |
| 10 | Revenue | |
| 11 | Total variable costs | |
| 12 | Contribution | |
| 13 | Contribution margin ratio | |
| 14 | Operating profit | |
| 15 | ||
| 16 | Accounting view | |
| 17 | Cost of goods sold | |
| 18 | Gross margin | |
| 19 | Operating margin |
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