Understanding Business Accounting For Dummies, 2nd Edition (68 page)

Note that we stop at the earnings before tax line in this calculation. You're aware, of course, that business profit is subject to tax. Chapter 3 provides a general overview of the taxation of business profit. This chapter focuses on profit above the taxation expense line. Nevertheless, please keep in mind as a broad rule of thumb that taxable income of a regular business corporation is subject to around 30 per cent tax in addition to value added - except small businesses whose taxable income is taxed at a lower rate.

Contribution margin
is what's left over after you subtract cost of goods sold expense and other variable expenses from sales revenue. On a
per unit
basis the business sells its product for £100, its variable product cost (cost of goods sold) is £60, and its variable operating cost per unit is £8 - which yields £32 contribution margin per unit.
Total
contribution margin for a period equals contribution margin per unit times the units sold during the period - in the business example, £32 × 520,000 units, which is £16,640,000 total contribution margin. Total contribution margin is a measure of profit
before fixed expenses are deducted
. To pay for its fixed operating expenses and its interest expense, a business needs to earn a sufficient amount of total contribution margin. In the example, the business earned more total contribution margin than its fixed expenses, so it earned a profit for the year.

Here are some other concepts associated with the term
margin
, which you're likely to encounter:

Gross margin, also called gross profit:
Gross margin = sales revenue - cost of goods sold expense. Gross margin is profit from sales revenue
before
deducting the other variable expenses of making the sales. So gross margin is one step short of the final contribution margin earned on making sales. Businesses that sell products must report gross margin on their
external
profit and loss accounts. However, GAAP standards do
not
require that you report other variable expenses of making sales on external profit and loss accounts. In their external financial reports, very few businesses divulge other variable expenses of making sales. In other words, managers do not want the outside world and competitors to know their contribution margins. Most businesses carefully guard information about contribution margins because the information is very sensitive.

Gross margin ratio:
Gross margin ratio = gross margin ÷ sales revenue. In the business we use as an example in this chapter, the gross margin on sales is 40 per cent. Gross margins of companies vary from industry to industry, from over 50 per cent to under 25 per cent - but very few businesses can make a bottom-line profit with less than a 20 per cent gross margin.

Markup:
Generally refers to the amount added to the product cost to determine the sales price. For example, suppose a product that cost £60 is marked up (based on cost) by 662⁄3 per cent to determine its sales price of £100 - for a gross margin of £40 on the product.
Note:
The markup based on
cost
is 662⁄3 per cent (£40 markup ÷ £60 product cost). But the gross margin ratio is only 40 per cent, which is based on
sales price
(£40 ÷ £100).

Second path to profit: Excess over break-even volume contribution margin per unit

The second method of computing a company's profit starts with a particular sales volume as the point of reference. So, the first step is to compute this specific sales volume of the business (which is not its actual sales volume for the year) by dividing its total annual fixed expenses by its contribution margin per unit. Interest expense is treated as a fixed expense (because for all practical purposes it is more or less fixed in amount over the short-run). For the business in the example, the interest expense is £750,000 (see Figure 9-2), which, added to the £13,090,000 fixed operating expenses, gives total fixed expenses of £13,840,000. The company's
break-even point
, also called its
break-even sales volume
,
is computed as follows:

£13,840,000 total annual fixed expenses for year ÷ £32 contribution margin per unit = 432,500 units break-even point (or, break-even sales volume) for the year


In other words, if you multiply £32 contribution margin per unit by 432,500 units you get a total contribution margin of £13,840,000, which exactly equals the company's total fixed expenses for the year. The business actually sold more than this number of units during the year but, if it had sold only 432,500 units, the company's profit would have been exactly zero. Below this sales level the business suffers a loss, and above this sales level the business makes profit. The break-even sales volume is the crossover point from the loss column to the profit column. Of course, a business's goal is to do better than just reaching its break-even sales volume.