What Is the Weighted Average Contribution Margin in a Break Even Analysis?
The goal of just about every business is making a profit, and break-even analysis helps you understand just how much business you need to do to reach that goal. When you sell more than one thing, as most business do, break-even analysis relies on a figure called "weighted average contribution margin" to tell you how much closer to profitability you get with each sale.
Break-even analysis involves figuring out how much you need to sell to cover all your costs and start making profit. Break-even analysis requires separating your company's costs into two categories: fixed and variable. Your fixed costs are those that stay the same regardless of how much business you do. Variable costs are those that change according to how much you sell. If you owned, say, an ice cream shop, the rent on the store would be a fixed cost, while ice cream ingredients would be variable costs. Whether you sold no ice cream or 1,000 cones a day, your rent would be the same, but the more ice cream you sold, the more you'd pay for ingredients.
The contribution margin on any given product is the revenue you get from selling it minus the variable costs required to make the sale. If you sell an ice cream cone for $4, and each cone carries $1.50 in variable costs -- such as the ingredients and the direct labor involved in making the ice cream -- then the contribution margin for each cone is $2.50. Each cone you sell contributes $2.50 toward paying your business's fixed costs. If you have $3,000 a month in fixed costs, then you'd have to sell 1,200 cones a month to break even. After you sold 1,200 cones, every additional cone would generate $2.50 in profit.
Most businesses sell more than one thing, so most companies' sales will be a mix of higher- and lower-margin items. This is where the weighted average contribution margin comes in. The weighted average takes the combined contribution margin from all sales and then divides it by the total number of items sold. The result tells you, on average, how much of a contribution you get from each item you sell, whatever it is. A note of caution: Weighted average contribution margin is reliable for break-even forecasting only if your sales mix -- the proportion of your total sales represented by each particular product -- remains roughly the same.
Say that instead of selling just ice cream cones, you sell four products: cones, shakes, sundaes and cookies. Cones are 40 percent of your business and have a contribution margin of $2.50 apiece. Shakes are 25 percent and have a margin of $1. Sundaes are 20 percent, with a margin of $3. And cookies are 15 percent, with a margin of $1.50. Out of every 100 sales, you'll sell 40 cones, with a total contribution margin of $100 (40 x $2.50). You'll sell 25 shakes with a total margin of $25; 20 sundaes with a margin of $60; and 15 cookies with a margin of $22.50. Total margin for all 100 sales: $162.50. That's $1.625 per item sold. The $1.625 figure is the weighted average contribution margin. If you have $3,000 a month in fixed costs, you'll need to sell about 1,847 items to break even -- assuming that the 40/25/20/15-percent sales mix holds into the future.