Getting To The Black

A common metric for evaluating profitability or success of a project or business is net income. What is the bottom line? It turns out that the bottom line isn’t the best place to look. A more effective tool is the contribution margin. 

 

Contribution margin is equal to revenue minus variable costs. This can also be calculated on a per unit basis. Variable costs are costs that fluctuate each production cycle such as labor. A fixed cost is static. For example, insurance premium or building rent is going to be the same each period regardless of how much product is produced. Click to read more about variable and fixed costs.

 

There are two main uses of the contribution margin.  The first is to understand the actual profit added to the company. A product can have positive contribution margin, but a negative net income. In this scenario, there could be latent fixed costs that have been misallocated or can be controlled as opposed to the product being a dud. For example, rent on the storage warehouse will be a predetermined amount each period and will not be affected by the actual levels of production. Ideally, the budgeting process took both items into account. However, what is budgeted and what actually happens can be different things. If the business owner was able to use other storage space more efficiently and eliminate this rent expense or find cheaper rent, then net income would increase. The amount of profit the product is adding has not changed in either case, so just eliminating the product line can hurt net income. 

 

The second benefit is it allows break-even points to be calculated. The break-even point is the production level that revenue equals total costs. By dividing the fixed costs across the contribution margin per unit, the volume of production to cover the costs will be found. This formula can be grown to include the cost of taxes with a desired income level as seen below. This will allow the firm to set production or sales goals to reach a certain outcome beyond just covering the total costs of production. For example, let’s say total fixed costs are $150,000. The tax rate is 34%. The product has a contribution margin per unit of $1.11 and you have an operational goal of $1 million net income.