Arsho Baloch 03123369333

Sindhi_war@yahoo.com

Definition and explanation of contribution margin

Contribution margin is the amount remaining from sales revenue after variable expenses have been
deducted. Thus it is the amount available to cover fixed expenses and then to provide profits for the
period. Contribution margin is first used to cover the fixed expenses and then whatever remains go
towards profits. If the contribution margin is not sufficient to cover the fixed expenses, then a loss
occurs for the period. This concept is explained in the following equations:
[ Sales revenue Variable cost* = Contribution Margin ]
*Both Manufacturing and Non Manufacturing
[ Contribution margin Fixed cost* = Net operating Income or Loss ]
*Both Manufacturing and Non Manufacturing
For further clarification of the basic concept of cost volume and profit Analysis (CVP analysis) we
now take an example.

Example:
Assume that Masers A. Q Asem Private Ltd. has been able to sell only one unit of product during the
period. If company does not sell any more units during the period, the company's contribution margin
income statement will appear as follows:

Masers A. Q. Asem Private Ltd

Contribution margin Income Statement
For the month of------------Total
Sales (1 Unit only)
$250
Less Variable expenses
150
-----------Contribution margin
100
Less fixed expenses
35,000
-----------Net operating loss
$(34,900)
======

Per Unit
$250
150
-----------100
======

For each additional unit that the company is able to sell during the period, $100 more in contribution
margin will become available to help cover the fixed expenses. If a second unit is sold, for example,
then the total contribution margin will increase by $100 (to a total of $200) and the company's loss will
decrease by $100, to $34800. If enough units can be sold to generate $35,000 in contribution margin,
then all of the fixed costs will be covered and the company will have managed to at least break even
for the month-that is to show neither profit nor loss but just cover all of its costs. To reach the break
even point, the company will have to sell 350 units in a period, since each unit sold contribute $100 in
the contribution margin. This is shown as follows by the contribution margin format income
statement.

Masers A. Q. Asem Private Ltd

Contribution Margin Income Statement
For the month of------------Total
Per Unit
Sales (350 Units)
$87,500
$250
Less variable expenses 52,500
150
----------------------Contribution margin
35,000
$100
Less fixed expenses
35,000
======
-----------Net operating profit
$0
======
Note that the break even is the level of sales at which profit is ZERO.
Once the break even point has been reached, net income will increase by unit contribution margin by
each additional unit sold. For example, if 351 units are sold during the period then we can expect that
the net income for the month will be $100, since the company will have sold 1 unit more than the
number needed to break even. This is explained by the following contribution margin income
statement.

Masers A. Q. Asem Private Ltd

Contribution Margin Income Statement
For the month of------------Total
Per Unit
Sales (351 Units)
$87,750
$250
Less Variable expenses
52,500
150
----------------------Contribution margin
35,100
100
Less fixed expenses
35,000
======
-----------Net operating loss
$100
======
If 352 units are sold then we can expect that net operating income for the period will be $200 and so
forth. To know what the profit will be at various levels of activity, therefore, manager do not need to
prepare a whole series of income statements. To estimate the profit at any point above the break
even point, the manager can simply take the number of units to be sold above the breakeven and
multiply that number by the unit contribution margin. The result represents the anticipated profit for
the period. Or to estimate the effect of a planned increase in sale on profits, the manager can simply
multiply the increase in units sold by the unit contribution margin. The result will be expressed as
increase in profits. To illustrate it suppose company is currently selling 400 units and plans to sell 425
units in near future, the anticipated impact on profits can be calculated as follows.
Increased number of units to be sold
Contribution margin per unit
Increase in the net operating income

25
100
-----------2,500
======

To summarize these examples, if there were no sales, the company's loss would equal to its fixed
expenses. Each unit that is sold reduces the loss by the amount of the unit contribution margin.
Once the break even point has been reached, each additional unit sold increases the company's
profit by the amount of the unit contribution margin.