Contribution margin is the incremental profit generated by each additional unit produced and sold. The contribution margin is calculated by subtracting variable costs of producing and selling one unit from the sales price of a unit. The contribution margin can also be described as the amount of sales revenue that remains after subtracting out variable costs.
Contribution margin is often similar to gross margin, but is not exactly the same. The difference comes from contribution margin using all variable costs, not just the ones associated with manufacturing. Also, the cost of goods sold figure used in calculating gross margin usually incorporates overhead and other costs that are include fixed costs.
The Importance of Contribution Margin
Profit making is one of the major goals of a firm. Profit can only be achieved when products are sold for total revenues that exceed their cost of production. The total cost of production includes all expenses associated with the production of goods, including labor, raw materials, capital and rent. The costs may be fixed or variable depending on whether they increase with an increase in the number of units produced. Variable costs are considered for the purposes of contribution margin analysis, since they can be related directly to each product that is generated.
This analysis considers variable costs and not fixed costs, because the variable costs go up or down depending on the number of units produced. Fixed costs are “sunk costs” and would be incurred even when no production takes place, and so they are not useful in determining the direct gains made in producing and selling more units of a product.
Contribution margin analysis calculates how variable costs and sales generate marginal profit, the money made by producing and selling one additional unit. This number is the amount of money each unit sold contributes to the firm’s profit or to paying back fixed costs. It is the benefit of each additional sale. Contribution is important, because it can be related to profit goals or break-even analysis.
Contribution Margin Calculations
Contribution calculations can be performed on a per unit or a total basis. The math is simple:
Contribution Per Unit = Unit Sales Price – Per Unit Variable Cost
Contribution Per Unit = (Total Sales – Total Variable Costs) / (Number of Units Sold)
The total contribution can be calculated as:
Total Contribution = Total Sales – Total Variable Costs
Total Contribution = (Contribution Per Unit) x (Number of Units Sold)
Using total sales and total variable costs produces weighted-average contribution margin (WACM) across all products:
WACM = (Total Contribution Margin for All Products) / (Total Number of Products)
Contribution Margin Ratio = (Total Contribution)/(Total Sales)
Contribution Margin Ratio = (Contribution Per Unit)/(Unit Sales Price)
Contribution Margin Analysis
The contribution margin ratio is important, as it helps determine how the total contribution would change with a change in sales. The higher the contribution margin ratio, the better for a firm, since it implies that fixed costs can be paid more easily and a firm is more profitable.
Contribution margin analysis is an important tool for decision-making for firms with regard to pricing and operating leverage. A firm’s operating leverage can be analyzed by comparing the variable costs and fixed costs. The variable used for the contribution margin analysis can also be used to get the break-even point of sales or units produced and further influence decision-making. A firm reacts to a low contribution margin by cutting variable costs or by increasing revenues through raising prices.
Finding the Break-Even Point
Break-even analysis is a common tool used to investigate the feasibility of a new business or a new product. This analytical method is commonly used by managerial accountants and production management. It is also known as cost–volume–profit analysis. The break-even level of production could be expressed in terms of dollar sales or unit sales. It indicates the minimum quantity of units an organization needs to produce and sell in order neither lose nor make money.
The break-even point is where the total cost of production and the total amount of revenue generated from that level of production are exactly equal to each other, causing there to be no profit and no loss. Total cost includes both fixed costs like rent and variable costs like direct materials used in assembly of a product.
Hence, we can say that break-even analysis is an important tool to find the level of output required for a new business or a new product. It is also a tool that can be used as a benchmark to measure a company’s short-term goals.
Finding the Break-Even Point
The break-even point is typically found graphically or by using an easy math calculation.
Total cost and revenue are often represented as curves on a graph, and where they intersect is the break-even point. At this point the firm earns no profit and no loss. The graph is based on the assumption that the total variable cost increases as the number of units increases, but the fixed costs remain constant or same. Also, total revenue is assumed to increase as total volume or output increases. At levels of production where sales exceed total costs, a profit is earned. At levels of production where total costs exceed sales, a loss is endured. And, total costs equal total sales at the break-even point.
We can also calculate the break-even point. In order to compute the break-even point, three basic pieces of information are required: average per unit sales price, average per unit variable cost and average annual fixed costs.
Break-Even Units = Fixed Cost / (Unit Sales Price – Unit Variable Cost)
Consider a hat manufacturer that makes and sells hats. He sells hats at a retail price of $30 each. The average variable cost per hat is $20, and the fixed cost of production is $50,000. Compute the break-even units and sales level.
Average per Unit Sales Price = $30 per hat
Average per Unit Variable Cost = $20 per hat
Average Annual Fixed Costs = $50,000
Break-Even Units = 50,000 / (30 – 20) = 5,000 hats
Hence, no profits would be made from this hat business until he sells over 5,000 hats. That’s sales of $30 x 5,000 = $150,000 in sales just to break even.
Using Break-Even Analysis
To be clear, a company’s management hopes to produce more than the number of units needed to reach the break-even point, so that it can earn a profit and a return on investment. If the predetermined profit target could not be achieved, even if this means selling a considerable number of units above the break-even point, the company may shut down operations and sell assets related to the project. The break-even point is not a long-run goal for a project that should be making an accounting profit and have a positive net present value.
However, break-even analysis can be useful in the following ways:
It helps evaluate new product launches, since it projects the volume of output at which a company could produce a new product without any accounting losses or the level of output in which the loss breaks in the profits.
It can determine if the company should add to its fixed costs to take advantage of unused capacity.
It can identify projects that are generating losses and should be radically altered or shut down.