Contribution Margin and Breakeven Analysis
Determining when a Company will Realize a Profit
Sep 19, 2009
Reviewing a company’s financial statements does not always offer an accurate depiction of how a business is performing. Useful analysis techniques have been developed to help offer a more complete picture of a company’s financial health. The break-even point, contribution margin and reviewing fixed and variable costs are all important analysis tools in helping to determine where a company stands and at what point the company will begin to realize a profit.
To properly asses a company’s financial health, useful analysis techniques will include a review of fixed costs, variable costs, the break-even point and the contribution margin. These analytical tools are only a few that can be used to gauge how a company is doing. A break-even analysis is based on fixed costs, variable costs per unit of sales and revenue per unit of sales.
Fixed and Variable Costs
Fixed costs are those costs that are always present, regardless of how much or how little is sold. Some examples of fixed costs include rent, insurance and salaries. Variable costs are the costs that increase or decrease in proportion to sales. Some examples of variable costs are raw materials, delivery expenses and sales commissions.
The contribution margin is calculated as the total revenue from a product or service less the total variable cost. The key point in understanding contribution margin is to understand that as revenues increase from selling more products or services, variable expenses will increase at a proportionate rate. The contribution margin will also increase at a proportionate rate.
According to Marshall, McManus and Viele, (2003), using the contribution margin as an analysis tool will help gauge “the impact of cost and sales volume changes on operating income.” Understanding the contribution margin as well as fixed costs, variable costs and the break-even point, are important points as they lend much insight into income, costs and profits.
A Company’s Financial Statements Does Not Offer All Information
Reviewing a company’s financial statements does not always offer a clear picture of how specific aspects of a business are doing. To gain deeper insight into how a business is doing, useful analytical techniques have been developed to help. Break-even analysis and contribution margin are among some popular analysis tools for helping to gain a greater depth of understanding and analysis into a company’s financial health.
Fixed costs and variable costs are figures one must track in order to use some of the analytical techniques available. These are vitally important costs to track as they affect a company’s bottom line. There is not one ratio or analysis technique that will offer everything one needs to know about the financial aspects of a business. Therefore, understanding the use of various financial ratios and techniques can help in gaining a more complete picture of a company’s financial outlook.
Reference
Marshall, D., McManus, W., Viele, D. (2003). Managerial Accounting and Cost-Volume-Profit Relationships. Accounting: What the numbers mean (6th ed.). New York: McGraw-Hill. Ch. 12. Retrieved November 18, 2005 from University of Phoenix Online.
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