Question

What is contribution margin? How does it differ from an operating leverage? Discuss, with an example, how contribution margin is used to determine a break-even quantity?

Answer 1

Answer to part (1):

Contribution Margin refers to the incremental money generated for each product or service sold by a firm after deducting the variable costs(costs that varies with production or discharge of service) associated with the production of the good or discharge of the service .

Contribution Margin is calculated as follows:

Contribution Margin= Sales Revenue-Variable Costs

It can be determined on a gross or a per unit basis.

Answer to Part (2):

Operating Leverage measures the degree to which a firm can increase its operating income by increasing its revenue on the other hand Contribution Margin  refers to the incremental money generated for each product or service sold by a firm after deducting the variable costs(costs that varies with production or discharge of service) associated with the production of the good or discharge of the service.

Operating Leverage is calculated as the ratio of Contribution Margin to Net Profit while on the other hand Contribution Margin is calculated as the difference between Sales and Variable Costs.

Answer to Part (3):

Contribution Margin can be used to determine the break-even analysis in the following way as given in the example

Example

Suppose Company X sells its product at $ 200 each., total variable costs are $ 140 per unit.Thus:by substituting these values into the Contribution Margin we get:

Contribution Margin= $200-$ 140 ie. $ 60 per unit

We also know that the firm has a total fixed costs of $ 60,000

Now let us calculate the break even point in units:

Break-Even point in units= Total Fixed Costs/Contribution margin.Substituting these values into the formula we get:

Break-Even Point (in Units)= $60,000/$ 60 per unit ie. 1000 units

This means that when the firm will sell 1000 units it will neither make a profit nor make a loss and will cover all is fixed costs.