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The Contribution Margin
and Your Break Even Point...


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  7. Contribution Margin and Your Break Even Point

The contribution margin is the unit price for your product or service less the variable cost per unit and it is a very useful number to know and understand.

creating an online home business

As a new business it is sometimes difficult to establish the sales volume for your break-even analysis.

One way around that difficulty is to use the contribution margin method.

To calculate the break-even point for your product or service you need to know the sales volume or the dollar value of total sales.

Sales - ([Variable Cost per Unit x Sales Volume] - Fixed Costs) = 0

As you are starting out, it may be difficult to work out the numbers.

Rather than just randomly guessing at the numbers and plugging them into the formula until you find the right number, it might be easier to take another approach. 

The Contribution Margin Approach

As I said above, the contribution margin is the unit price for your product or service less the variable cost per unit.

It is called a contribution margin as it is the portion of your sale price that is available to cover your fixed costs after paying the variable costs of your product or service.

If you have worked your way through the previous sections about determining the profit potential of your business model, you will have identified your variable product costs, your fixed costs, and worked out the price for your product.

With this information you are able to calculate how many units you need to sell to recover your fixed costs.

Contribution Margin = Unit Price / Variable Cost per Unit

Break-even Volume = Fixed Costs / Contribution Margin

Need an Example?

Let's assume that your unit price is $10, variable costs per unit are $6, and your fixed costs are $20,000.

Using the contribution margin method of calculating the break-even point, your contribution margin is:

$10 - $6 = $4 per unit

Your break-even volume is:

$20,000 / $4 = 5,000

In other words, you need to sell 5,000 units to break-even.

Just to check the figures, we can try the original break-even formula. But first we need to calculate the sales value by multiplying the sales volume by the unit price.

Total Sales Value is: 5,000 * $10 = $50,000

Now we can plug the numbers into the formula, and as you can see the break-even volume predicted by our contribution margin approach is verified by the break-even calculation.

Break-even = $50,000 - ([$6 per Unit x 5,000] - $20,000 = 0 

What the Results Allow You to Do...

Once you have calculated your break-even volume, you must ask yourself how reasonable it is. In the example above, the business would need to sell 5,000 units of the product just to break even. That volume does not include any allowance for profit, or any form of return on your investment in the business.

The question you need to ask is can you sell at least that volume of products or services?

If the answer is no, then you have a serious issue with your business model and may need to do some fairly major revisions to your model. If you are determined to go ahead with your model as it is, other things you might like to look at are:

  • Can you increase the unit price?
  • Can you reduce your variable costs per unit?
  • Can you reduce your fixed costs?

But bear in mind that if you are facing this issue before you even start, it is not a good sign for the long-term viability of your business!



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