Understanding Contribution Margin for Internal Decision Making

You should already be familiar with the term "gross margin," from your financial accounting class. But as a reminder, gross margin is simply revenues minus product and service costs (but excludes SG&A). However, as we saw in RegionFly, relying on gross margin to make decisions is problematic. Specifically, in RegionFly, we saw that dropping a route may not result in expected cost reductions. This is because some of the costs were fixed and did not decrease. Instead, at the end of the lecture, we conducted an additional "accept or reject" exercise and introduced the idea of "contribution margin." Unlike "gross margin," the contribution margin calculation does not include fixed costs. Specifically, it is defined as revenue minus all variable costs (including variable SG&A). Why is "contribution margin" preferable for the purpose of internal decision making? For one, using contribution margin allows me to calculate "breakeven volume."Breakeven volume is the volume of product or service I need to sell in order to pay all of my fixed costs. An example of this is on slide 58 for week 1's lecture. In that example, we sell a unit of some product for $20, and the variable cost to produce that unit is $10 (i.e., $7 + $3). We have fixed costs of $150,000. Fixed costs are costs that we incur regardless if we manufacture anything (e.g., factory rent, employee salaries, etc.). The important question we need to ask is: How many units do I need to sell to cover my fixed costs? By definition, this is a "breakeven" calculation. In this case, the answer is 15,000 units. This is because, revenue minus all variable costs is $10; and $150,000 divided by $10 is 15,000 units. If we sold 15,000 units we could exactly cover the fixed costs, and this is the 'breakeven' point. This is visually displayed on slide 59 of week 1's lecture slides. From now on, we will focus on "contribution margin" in this course, since it is much more useful to decision making (as compared to gross margin).