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# contribution margin

last edited by 12 years, 7 months ago

# Contribution Margin: # Process:

2.  what are your variable costs

3.  Subtract V.C from revenue to get your contribution margin  from here, if you subtract your fixed costs, you will find your profits.  (The breakeven point is when the profits =0)

### If you want the breakeven point, then...

4.  now try to figure out the volume that makes your total contribution = to your total fixed costs

### how?

5.  Basic algebra needed here:   pick some variable (x) and call that your volume at breakeven (assume you are at the B.E.P, and that (x) is the volume)

6.  So, (x) time the contribution margin = fixed costs

7.  Solve for (x)

# Variable Income statement

Revenues

-All Variable costs:

VMCGS (variable manufacturing COGS) *does not include FFO

VS&A (variable sales and admin costs)

____

C.M. (contribution margin)

-All Fixed costs

___

Operating Income

- taxes

___

Net Income

This is different than the standard Gross Margin income statement that companies normally use when reporting (based on absorption costing). The Gross Profit income statement is different in that it combines all inventoriable costs into the COGS figure at the top (FFO is included in the COGS when the firm sells the products), and it also shows all S&A expenses as period costs at teh bottom of the Income statement, as shown here:

## Breakeven analysis When looking at a proposed project, it is useful to conduct a breakeven analysis to see how many units must be sold to cover your fixed costs.  This "job order costing" is done to figure out the amount of risk there is in the project.

The first thing you need to do is to make a Variable income statement, and figure out what is the contribution margin (revenues - variable costs).  You then subtract all of your fixed costs to come up with your operating income.  Subtract taxes to get your net income.  The goal is to make sure that you have enough contribution margin from this one project to cover your fixed costs of taking on this project (but please just consider only the relevant fixed costs for this project, and do not include non-relevant cash flows).

The "indifference point" is where the project breaks even, ie where contribution margin just barely covers the fixed costs.

The risk of the project is determined by the operating leverage (contribution margin / net income).  the higher the operating leverage, the more risk of the project (or firm).  This is because if you take on additional debt (fixed interest costs), then the gap between C.M and N.I will be higher, which will result in a higher operating leverage ratio.  (net income will decrease with additional fixed expenses, but C.M stays high, so the ratio of CM / NI will be larger with added fixed costs).

This ratio is extremely useful when comparing two projects (or two companies).  The one with the higher operating leverage will show much higher returns at higher volumes of sales, but will suffer much larger losses at lower volume of sales.  We call it "leverage" because of the amplification effect.

## From wikipedia:

Contribution arises in Cost-Volume-Profit Analysis, where it simplifies calculation of Net Income, and especially break even analysis.  Given the contribution margin, a manager can easily compute breakeven and target income sales, and make better decisions about whether to add or subtract a product line, about how to price a product or service, and about how to structure sales commissions or bonuses.Contribution margin analysis is a measure of operating leverage: it measures how growth in sales translates to growth in profits.

The contribution margin is computed by using a contribution income statement: a management accounting version of the income statement that has been reformatted to group together a business's fixed and variable costs. 