What Happens to a Contribution Margin When Fixed Costs Increase?
The contribution margin and fixed costs are closely related. Both are important parts of the cost-volume-profit analysis, an analysis used by business to set policy and strategy. Other cost-volume-profit analyses include the break-even point, a calculation that uses the contribution margin and fixed costs to determine when a company operates at a point where revenue and expired costs are equal.
The contribution margin is sales less costs, including costs related to goods sold and administration. While using the contribution margin, one must assume that all factors but sales volume remain constant.
A related concept is the contribution margin ratio, which is the percentage of each sales dollar that is available to cover fixed costs and provide income. It measures the effect of changes in sales volume from operations. The contribution margin is a cost-volume-profit analysis; it examines the relationship of profits, expenses, costs, production volume, sales and selling prices.
Fixed costs do not change because of varying rates of activity. Examples of fixed costs are rents and property taxes. Fixed costs can change, but not due to production activity. Variable costs are the opposite of fixed costs and vary according to levels of activity. An example of a variable cost, which is the same per unit but changes in proportion to the activity base, includes wood used to make chairs.
Fixed and variable costs are closely related to the contribution margin and the contribution margin ratio. An increase in fixed costs adds to overall cost. This would reduce how much the company earns from operations if the contribution margin is low. Such a small contribution ratio means that a company should focus on reducing costs.
Here is a calculation showing such a situation. It compares the difference between high and low contribution margins.
First determine the contribution margin ratio; the equation is contribution margin ratio = sales – variable costs/sales:
> 2,000,000 – 1,000,000/2,000,000 =.50, or 50 percent
Then add the contribution margin to the contribution margin income statement: Sales -- $2,000,000 Variable costs ($2,000,000_.50) -- $1,000,000 Contribution margin -- ($2,000,000_ . 50) -- $1,000,000 Fixed costs -- $500,000 Income from operations -- $500,000
Now reduce costs, which allows the company to focus on sales volume if capacity is not at 100 percent.
> 2,000,000 – 1,000,000/2,000,000 = .50, or 50 percent Sales -- $2,000,000 Variable costs ($2,000,000*.50) -- $1,000,000 Contribution margin -- ($2,000,000 * 50) - $1,000,000 Fixed costs -- $200,000 Income from operations -- $800,000
This shows increased income from operations by decreasing the fixed costs. If the contribution margin increases because of an increase in variable costs, you would have to reconsider your strategy to focus on sales volume. First determine the break-even point before determining your strategy.
The break-even point is another form of cost-volume-profit analysis. It is the point at which revenues and expired costs are equal. The break-even point equation is fixed costs/unit contribution margin.
One must first determine the unit contribution margin to calculate the break-even point. Do this by subtracting the unit variable cost from the unit selling price. Then divide the fixed costs by the unit contribution margin. Such a calculation may look like this: $200,000/$500 = $400.