As we have a deep look at break even point analysis and why it’s essential for business owners to understand if they intend to navigate their businesses to profitability, the focus so far has been on the difference between variable costs and fixed costs.
We also need to understand contribution margin and here is why.
The Break Even Point Formula
The basic way to calculate the break even point as a sales value is:
Contribution margin %
If you know the contribution margin per unit, you can use that instead to calculate the sales volume needed in units of sale.
What Is The Contribution Margin?
Contribution (margin) is the difference between the sales price received from the customer and the variable costs of buying, making and delivering the product or service.
These costs are also sometimes called marginal costs or direct variable costs.
You may already know this as gross margin or gross profit but too often, these measures are shown in the accounts after the deduction of some fixed costs which will cause confusion and potentially lead to wrong decisions.
A Numbers Example To Give You A Deeper Understanding
Let’s look at an example.
I know it takes mental effort to work through the numbers but please concentrate. You may want to grab your calculator and do the arithmetic as you read.
Assume you sell 500 units for £30 each, making a total sales revenue of £15,000 in a month.
You buy these units for £12 each, giving a total cost of sales of £6,000.
You also pay courier charges to get these goods to the customers of £1,200.
The goods are despatched from your warehouse by your two staff who earn £1,500 each and the rent on the warehouse is £1,000 for the month.
The variable costs mentioned above are the cost of buying the goods sold of £6,000 and the courier costs of £1,200.
The warehouse wages and rent are fixed costs because they don’t vary directly with your sales volume. If you’d sold 300 units or 700, these costs would have been the same.
The contribution margin is therefore:
Sales Revenue £15,000
Less Goods Sold £6,000
Less Courier Costs £1,200
Contribution Margin = £7,800
This margin can be expressed as a % of sales revenue = 52%
Or as a contribution per unit = £7,800/500 units = £15.60
With fixed costs of:
Warehouse wages = £3,000
Rent = £1,000
Total fixed costs = £4,000
The profit for the month is contribution – fixed costs = (7,800 – 4,000) = £3,800.
The break event point is:
In units (4000/15.60) = 256.4 units.
In sales value (4000/52%) = £7,692
We can check on the break even sales value by multiplying the number of break even units by the average selling price – 256.4 units at £30 each = £7,692
If you’re not familiar with break event points, please read
I hope you’ve understood so far because we’re going to get into the really important ideas about contribution margin next and why sales value can be such a misleading measure of performance.
Contribution Margin Is The Real Income Of A Business
Business owners can get into a mess if they focus too much attention on the value of sales revenue and too little on the value of the contribution margin.
To prove the point, we can compare the sales value and contribution margin from two directions.
The first looks at what the contribution margin is at a constant sales revenue value but with different contribution rates % of sale.
Sales Revenue = £10,000, Margin % = 5%, Contribution = £500
Sales Revenue = £10,000, Margin % = 10%, Contribution = £1,000
Sales Revenue = £10,000, Margin % = 20%, Contribution = £2,000
Sales Revenue = £10,000, Margin % = 30%, Contribution = £3,000
Sales Revenue = £10,000, Margin % = 40%, Contribution = £4,000
Sales Revenue = £10,000, Margin % = 50%, Contribution = £5,000
Sales Revenue = £10,000, Margin % = 60%, Contribution = £6,000
Sales Revenue = £10,000, Margin % = 70%, Contribution = £7,000
That looks pretty easy to understand, doesn’t it?
There’s a linear relationship between sales value and contribution value.
It’s obvious and intuitive.
But what if we look at it from the other direction.
Let’s assume that we have fixed costs of 5,000 to meet each month and look at the sales value needed to break even at different contribution rates.
Remember, the break even point is fixed costs divided by the contribution margin. Each of these sales values will therefore generate a contribution margin of £5,000.
Fixed Costs = £5,000, Margin % = 70%, Break Even Sales = £7,143
Fixed Costs = £5,000, Margin % = 60%, Break Even Sales = £8,333
Fixed Costs = £5,000, Margin % = 50%, Break Even Sales = £10,000
Fixed Costs = £5,000, Margin % = 40%, Break Even Sales = £12,500
Fixed Costs = £5,000, Margin % = 30%, Break Even Sales = £16,667
Fixed Costs = £5,000, Margin % = 20%, Break Even Sales = £25,000
Fixed Costs = £5,000, Margin % = 10%, Break Even Sales = £50,000
Fixed Costs = £5,000, Margin % = 5%, Break Even Sales = £100,000
This simple business with fixed costs of £5,000 per month needs only £7,143 of sales revenue if it can achieve a contribution margin % of sales of 70%.
But to break even, it needs £100,000 of sales revenue if the contribution is only 5% of sales value.
The nice linear relationship of the contribution margin seen in the first set of numbers has turned exponential when we want to break even or to reach a fixed value of contribution.
It’s this suddenly more complicated relationship between sales and contribution margin that confuses business owners and managers when they think about discounting prices to increase sales or talk themselves out making a much needed price increase.
Can You See Why Contribution Margin Is Your Real Income?
If your business has margins that vary between products and/or between customers, can you see why I’d like you to reduce your focus on sales value and increase the attention you make to the contribution margin you make on sales?
It’s very easy to get fooled by a high sales value in a month and to think that your business is making lots of money.
It will be if you’ve managed to hold your contribution margins but if you’ve been discounting, you could be in for a nasty shock when the accountant does your monthly accounts.
Practical Implications Of Focusing On Contribution
Many businesses use a KPI system that reports the daily or weekly sales value to the owner-managers to indicate how well the business is performing during a month.
The same KPI report could also include order intake based on sales value as well.
This can be seriously misleading and if possible, should be replaced with a report of estimated contribution.
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