The contribution margin is a concept used with breakeven point or in break-even analysis. In words, the contribution margin is the amount of money a company has to cover its fixed costs after it pays all of its variable expenses. It is also the amount, after covering fixed costs, that contributes to the net operating profit or net operating loss of the business firm.
Equation Form
In equation form, the contribution margin is:
- Contribution Margin = Sales Revenue - Variable Expenses
- On a per unit basis, contribution is calculated as:
- Contribution Margin per unit of sales = Sales Revenue per Unit - Variable Expenses per Unit
- Contribution Margin - Fixed Costs = Net Operating Profit or Loss
Break Even Formula
The break-even formula calculates the point at which a company's sales are zero - there is no profit or loss:
- Break-even in Units = Total Fixed Costs/Contribution Margin per unit
- The denominator of this equation is the contribution margin. Imagine a company where fixed costs are $60,000, the price of the product is $2.00 per unit and variable costs are 80 cents per unit. Here is an example:
- Breakeven point = $60,000/$2.00 - $0.80 = 50,000 units
- The contribution margin in this case is $1.20 per unit. XYZ Corporation has to produce and sell 50,000 units of their products in order to cover their total expenses, fixed and variable. At this level of sales, they will make no profit but will just break-even with a contribution margin toward fixed costs of $1.20 per unit sold or $60,000 (50,000 X $1.20).
Gross Margin vs Contribution Margin
It is important for a financial manager to understand that, on the income statement, the gross profit margin and the contribution margin are not the same. The gross profit margin is the difference between sales and cost of goods sold. Cost of goods sold include all costs - fixed costs and variable costs.
The contribution margin only considers variable costs. The contribution margin is the difference between sales and variable costs. Calculating both can give the financial manager valuable, but different, information.
Contribution Margin Ratio
The contribution margin ratio is the contribution margin as a percentage of total sales. In this formula, you use the total contribution margin, not the unit contribution margin. Calculating this ratio is important for the financial manager as it addresses the profit potential of the firm.
Example:
Here is the contribution margin ratio: $40,000/$100,000 X 100 = 40%.
This means that for every dollar increase in sales, there will be a 40 cent increase in the contribution margin to cover fixed costs.
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