How to Estimate the Contribution Margin at a Certain Level of Production
A contribution margin measures the money a company has left over from sales revenue to pay for fixed expenses after paying variable expenses. Fixed expenses are those that you pay each accounting period that are independent of your sales volume, such as rent. Variable expenses increase when you make or sell more products. You can estimate your small business’s contribution margin at a certain level of production to determine how much money you will have available to cover your fixed costs. The amount of contribution margin that exceeds your fixed costs is your profit.
Add the variable expenses you incurred in your most recent period to calculate your total variable expenses. Include any costs that fluctuate in direct proportion to your production, such as raw materials, electricity to run your equipment, sales commissions, outgoing shipping costs and labor costs for employees who directly make your products. Include labor as a variable cost only if you pay workers per unit of production or if their work hours depend on production levels. If your employees work set hours or earn salaries, labor is a fixed cost. For example, assume your small business spent $4,000 on materials, $6,000 on shipping, $10,000 on labor and $1,000 on utilities to run your factory last month. Add these to get $21,000 in total variable expenses.
Divide your total variable costs by the number of units you produced last period to figure your variable costs per unit. In this example, assume you produced 2,000 units last month. Divide $21,000 by 2,000 to get a variable cost per unit of $10.50.
Multiply the level of production in units at which you want to estimate your contribution margin by your selling price per unit to determine your total revenue. In this example, assume you sell each unit for $25 and want to estimate your contribution margin in the current month at 2,500 units. Multiply 2,500 by $25 to get $62,500 in revenue.
Multiply your variable expenses per unit by your desired production level to estimate your total variable expenses at that production level. In this example, multiply $10.50 by 2,500 to get $26,250 in total variable expenses at 2,500 units.
Subtract your total variable expenses from your total revenue at your desired production level to estimate your contribution margin. Concluding the example, subtract $26,250 from $62,500 to get a $36,250 contribution margin when you make 2,500 units. This means you will have approximately $36,250 to pay toward fixed expenses.
Subtract your fixed expenses from your estimated contribution margin to estimate your net profit. A negative result represents a net loss, which means you need to increase production to generate a profit. Fixed expenses include items such as rent, loan payments, management and administrative wages and salaries, advertising, office utilities, insurance and property taxes. For example, if your monthly fixed expenses are $22,000 and your contribution margin is $36,250 at 2,500 units, you would make $14,250 in profit.
The production level at which your contribution margin equals your fixed expenses and at which your profit is zero is your break-even point.