Does a Contribution Equal a Fixed Cost?
In accounting, contribution margin actually refers to the difference between sales revenue and variable costs. Contribution is also known as gross profit. The contribution is the first profit level computed on a company's income statement. Contribution isn't directly related to fixed costs, though it does have a correlation in the progression toward net profit or loss.
Contribution Margin Example
Companies monitor two contribution calculations. Total contribution margin is the difference between periodic revenue and periodic variable costs. If you generated $30,000 in quarterly revenue and your variable costs were $15,000, for example, your contribution was $15,000. Contribution per unit looks at the difference between sales price and variable costs for a particular good. If you only sell one product in your business, sales of 1,000 units at $300 each equals your $30,000 total revenue. If your variable costs are $15 per item, you have a $15 per unit contribution.
Covering Fixed Costs
The relationship between contribution and fixed costs is sequential. To operate profitably, you must generate enough contribution margin to cover your fixed costs and then some. Fixed costs include building payments or rental fees, utilities, annual salaries and other expenses you incur regardless of production. If your contribution falls short of fixed costs, you incur an operating loss. If it exceeds your fixed costs, you have an operating profit.
To set profit goals, company leaders often use a breakeven formula. If you have $5,000 in fixed costs for your business, you know that you must generate at least $5,000 in contribution to break even for the month on basic operations. With the $15,000 in contribution margin, you would have made $10,000 in operating profit. With a per-unit margin of $15, you divide $5,000 in fixed costs by $15 to realize a breakeven point of roughly 333 units. If you sell more than that amount, you know you earn an operating profit.
Additional Contribution Considerations
To boost your contribution margin, you can either increase consumer demand and prices, or negotiate better variable costs with your suppliers. Stable or declining contribution margin percentage, in line with or above industry norms, is ideal. Just exceeding breakeven and generating an operating profit doesn't ensure net profit. Your business may incur irregular expenses, such as legal fees or bad debt write-offs, that could cause you to end up with a net loss.
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