# Contribution Margin and Basics of Cost Volume Profit (CVP) Analysis:

Learning Objectives:

1. Define and explain contribution margin.
2. Prepare a contribution margin format income statement.
3. What are the advantages of calculating contribution margin?

## 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 Per Unit Sales (1 Unit only) \$250 \$250 Less Variable expenses 150 150 ——— ——— Contribution margin 100 100 Less fixed expenses 35,000 ====== ——— Net operating loss \$(34,900) ======

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 25 Contribution margin per unit ×100 Increase in the net operating income 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.

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Learning Objectives:

1. Define and explain contribution margin.
2. Prepare a contribution margin format income statement.
3. What are the advantages of calculating contribution margin?

## 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 Per Unit Sales (1 Unit only) \$250 \$250 Less Variable expenses 150 150 ——— ——— Contribution margin 100 100 Less fixed expenses 35,000 ====== ——— Net operating loss \$(34,900) ======

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 25 Contribution margin per unit ×100 Increase in the net operating income 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.