Doing a profit analysis requires separating cost types, calculating the contribution margin and determining the breakeven point. Separating fixed from variable costs helps businesses assess which costs remain the same or fluctuate when there are changes in production. The contribution margin is used in the profit analysis for finding out how much profit is made per product without considering fixed costs. Knowing its breakeven point can help a business understand when its revenues exceed costs. The contribution margin and breakeven point can then be used as a benchmark for other companies.
Conducting a profit analysis begins with separating the business’s fixed costs from its variable costs. Fixed costs do not change when production levels such as overhead, management salaries and indirect labor fluctuate. Variable costs are those that increase as sales or production increases. Examples of variable costs include raw materials, direct labor and warehousing. These numbers will be needed to conduct a profit analysis when using the contribution margin, breakeven formulas.
Contribution margins can be done to calculate profit while excluding fixed costs for each product. The contribution margin is calculated by taking the total number of sales for a predetermined period of time and then subtracting its variable costs for the same period of time. If there are multiple products, then this should be done for each product separately. Comparing the contribution margin of each product can be helpful in seeing which products contribute more per sale to the company’s net operating income.
Breakeven point for a product is the number of items that must be sold in order to reach a profit. The breakeven point is calculated by dividing the contribution margin by the sales price per unit to come up with the contribution margin ratio. Next, the total fixed costs is divided by the contribution margin ratio to get the breakeven point. For example, if the contribution margin is $10 United States dollars (USD), the sales price per unit is $25 USD, and the total fixed costs is $50,000 USD, then the breakeven point will be 125,000 items. The business in this example would have to sell at least 125,001 items in order to see a profit.
Gathering the results of the contribution margin and breakeven point for analysis is the final step of the profit analysis. Results can be compared with those of other products, as well as with competitors’ results, to see if the business is efficiently using its variable and fixed costs. The business can determine if certain costs can be reduced by reviewing its list of variable and fixed costs, and then recalculate its contribution margin and breakeven points to see how changes could effect its profit. Companies should be careful about reducing costs, particularly when reducing the cost does not significantly impact the breakeven point but will affect the quality.