The contribution margin is a concept used with breakeven point or in break-even analysis. In words, the contribution margin is the amount of money a company has to cover its fixed costs after it pays all of its variable expenses. It is also the amount, after covering fixed costs, that contributes to the net operating profit or net operating loss of the business firm.
In equation form, the contribution margin is:
Contribution Margin = Sales Revenue - Variable Expenses
On a per unit basis, contribution is calculated as:
Contribution Margin per unit of sales = Sales Revenue per Unit - Variable Expenses per Unit
Contribution Margin - Fixed Costs = Net Operating Profit or Loss
The break-even formula calculates the point at which a company's sales are zero - there is no profit or loss:
Break-even in Units = Total Fixed Costs/Contribution Margin per unit
The denominator of this equation is the contribution margin. Imagine a company where fixed costs are $60,000, the price of the product is $2.00 per unit and variable costs are 80 cents per unit. Here is an example:
Breakeven point = $60,000/$2.00 - $0.80 = 50,000 units
The contribution margin in this case is $1.20 per unit. XYZ Corporation has to produce and sell 50,000 units of their products in order to cover their total expenses, fixed and variable. At this level of sales, they will make no profit but will just break-even with a contribution margin toward fixed costs of $1.20 per unit sold or $60,000 (50,000 X $1.20).