Contribution Margin

Our office had received a request from Andre, owner of Andre's Styling Saloon to perform an evaluation on his business.

Andre has five barbers that work in the establishment and each employee received a salary of $9.90 per hour and works a 40-hour week and a 50-week year, regardless of the number of haircuts. As rent and other fixed expenses he expends $1,750 every month, plus $ 0.40 as the cost of hair shampoo used on all his clients. This saloon is performing haircuts exclusively and each client paid a flat price of $ 12.00.

He wanted for us to evaluate a new compensation method for his employees. Under the new system the barbers will receive a flat salary of $4 per hour, and a commission of $ 6.00 for each haircut. In this case Andre wants to know how much is going to be the new contribution margin per haircut, the annual break-even point in number of haircuts.

On our evaluation, Andre requested to find the following information.

1. Find the contribution margin per haircut.

Contribution Margins Definition

"Contribution margin (or margins) refers to the amount of revenue per product that is available to "contribute" towards the fixed costs and the profit of the company. Since, for digital products, the variable costs are typically very small, or zero, most of the revenue earned from the sale of a product form the contribution margin. Assuming the contribution margin (unit price - unit variable cost) > 0, then the product is worth marketing, since the fixed costs are sunk. This also assumes the product does not cannibalize sales from another product in the product line, if so, the opportunity costs need to be considered" (Learnthat.com (2006)).

Contribution Margin= Unit Price - Unit Variable Cost

2. Determine the annual break-even point, in number of haircuts.

Break Even Analysis Definition

"Break Even Analysis refers to the calculation to determine how much product a company must sell in order to break even on that product. It is an effective analysis to measure the impact of different marketing decisions. It can focus on the product, or incremental changes to the product to determine the potential outcomes of marketing tactics. Learnthat.com (2006))

1. Find the contribution margin per haircut. We are going to assume that the barbers' compensation is a fixed cost.

To be able to calculate the contribution margin we need to deduct the unit variable cost from the sale price per unit. In our case the cost per each haircut is $ 12.00 and the variable price $ 0.40 that represents the cost of shampoo used for each customer.

Unit Contribution Margin: $ 11.60

Unit sale price: $ 12.00

Less variable cost: $ 0.40

Unit Contribution Margin = $ 11.60

2. Determine the annual break-even point, in number of haircuts. Support your answer with an appropriate explanation.

To be able to determinate the Annual Break Even Point we have to determinate the fixed cost first and divide the sum by the unit contribution margin obtained by subtracting the variable cost from the unit sale price.

Barber's Salaries:

Salary per barber per week: $ 396.00

Price per hour = $ 9.90, hours per week = 40

Weekly salary per barber: 9.90 * 40 = 396.00 or $ 396.00

Salary per barber by year: $ 19,800

Weekly salary per barber = $ 396, number of weeks per year = 50

Yearly salary per barber: 396.00 * 50 = 19,800 or $ 19,800

Andre's barbers salaries per year: $ 99,000

1 barber = $ 19,800, quantity of barbers= 5

Total salaries: 19,800 * 5= 99,000 or $ 99,000

Overhead Cost:

Rent: $ 1,750 per month, Yearly cost: $ 21,000

1750* 12 = 21,000 or $ 21,000

Fixed Cost: $ 120,000

Salaries + Overhead Cost

99,000 + 21,000 = 120,000 or $ 120,000

To be able to determinate the Annual Break Even Point we have to determinate the fixed cost first and divide the sum by the unit contribution margin obtained by subtracting the variable cost from the unit sale price.

Break- Even Point: 10,345

Fixed Cost / Unit Contribution Margin

$ 120,000/ $ 11.60= 10,345 haircuts

3. What will be the operating income if 20,000 haircuts are performed?

Net Operating Income - NOI

A company's operating income after operating expenses are deducted, but before income taxes and interest are deducted. If this is a positive value, it is referred to as net operating income, while a negative value is called a net operating loss (NOL).

Notes:

NOI is often viewed as a good measure of company performance. Some believe this figure is less susceptible than other figures to manipulation by management.

(Investopedia (2005))

OPERATING INCOME = REVENUES - (FIXED COSTS + VARIABLE COSTS)

Revenue calculations: $ 240,000

20,000 * $ 12.00 = $ 240,000

Overhead Cost:

Rent: $ 1,750 per month, Yearly cost: $ 21,000

1750* 12 = 21,000 or $ 21,000