Calculation
Calculation involves determining the price and costs of the product/service to assess how much you can earn from what you are selling.
Fixed and variable costs
During the calculation process, a distinction is often made between variable and fixed costs. A variable cost is directly linked to, and fluctuates in line with, production. Material costs incurred by manufacturing companies are a typical example of a variable cost. However, fixed costs will not vary in line with production. Rent is one example of a fixed cost.
The contribution method
When you use the contribution method, you will see how much you will be left with per product/unit to cover your fixed costs and any profit. You should use the sale price as a starting point and deduct all variable costs attributable to the product or service. The profit you are left with is called the contribution margin (CM). If you calculate the contribution margin as a percentage of your sales revenues, you will obtain the contribution ratio (CR). This method is commonly used by companies which manufacture goods or sell services.
Contribution ratio (CR) = Contribution margin (CM) per unit * 100/sale price per unit.
The contribution ratio is specified as a percentage and indicates what percentage of your turnover will be left over to cover fixed costs and profit.
When you start the calculation, you must quantify the variable costs you incur in order to manufacture the product or provide the service. It can also be a good idea to check what price your competitors are charging for their products or services. This will give you an indication of the price you will be able to charge.
If you sell several products or services, you should perform one calculation for each unit. When you know how much you will have left for each product (the contribution margin) to cover fixed costs and profit, you will be better placed to calculate the minimum number of units you will have to sell in order to cover your fixed costs for the entire business.
The challenge is often to determine what costs should be directly linked to each product. This is not a difficult task for some industries, but it can be more long-winded for others.
Example of a contribution calculation
Eksempelbedriften AS wants to manufacture a new product – a kitchen table to be called "Uffe".
The calculation is based on a number of assumptions: expected sale price, production time, salary costs and cost of materials in NOK.
| Prerequisites | Unit | |
|---|---|---|
| Sale prise | per unit | NOK 4000 |
| Production time | hours | 5 |
| Salary costs (including National Insurance costs) | per hour | NOK 300 |
| Materials – timber, tacks, glue | per unit | NOK 800 |
| Contribution Calculation | |
|---|---|
| Sales revenues | NOK 4000 |
| - Production salary (5 x 300) | NOK 1500 |
| - Materials | NOK 800 |
| = Contribution margin | NOK 1700 |
| Contribution ratio | (1700/4000*100)= 42.5% |
For this product, the contribution to cover fixed costs and profit will be NOK 1700 per unit sold. This gives a contribution ratio of 42.50%.
If the assumptions used in the calculation are accurate, the kitchen table will be profitable to produce. This assumes of course that the market is willing to pay the price you have set for the product and that you are able to sell a certain quantity.
