1$ of extra fixed costs = 1$ of extra sales???

“Does one dollar of extra fixed costs needs one extra dollar of sales to recover it?”

A logical answer is “one dollar“.  What if I would tell you that this is not true?  Let’s have a look!!

What is Contribution Margin (CM)?

Contribution Margin (CM) is highly used in menu engineering but it can also give answers to several other interesting financial areas.  One of them relates to the question raised above regarding the impact of fixed cost increases on sales and profits.

Let’s see how we can get a clear and accurate answer to the above question and how it can be used.

How does contribution margin work?

Contribution Margin is the selling price of a product minus its variable costs.  Let’s say that a burger’s selling price is $5 and all its variable costs (food, wages and other) are $3.  Then its CM is $2 or 40% of sales.

Therefore, we can sum up figures regarding ‘Burger’s CM’with 100 burgers sold in the following table 1:

One of the answers CM can provide is how much extra sales a business needs to make in order to cover each $ increase in its fixed costs.  A logical answer would be “an equivalent amount of dollars”.  This answer by far is not true since as sales increase by $1, automatically its variable costs increase because they behave in the same manner as sales .  This entails that the business needs first, to cover the increase in its relevant variable expenses and secondly, any other increase in its fixed costs.  Concluding, in order for a business to cover an increase of $1 of fixed costs it needs to use following formula:

($ increase in fixed costs/contribution margin %).

In our case $1/0.4 = $2.5.

Therefore, in this case, an increase of $1 in fixed costs needs to be accompanied with an increase in sales of $2.5 so that profits remain the same.