Question

1.What is a contribution margin and how is it different from gross margin? 2.What is the significance of the contribution margin ratio, and how is the ratio useful in planning business operations? 3.Explain what is meant by the margin of safety? 4.What does the margin of safety tell companies and how can they use this information?

Answer 1

1)

Contribution margin is the margin earned by enterprise by deducting variable expensed from income earned by it,

Such contribution is divided by total income to got the margin in percentage term,

Sales(income)

- variable expense

= contribution

Contribution margin = contribution/sales*100,

Contribution margin is different from gross margin as

Gross margin is margin earned by enterprise by deduction total cost (COGS) from sales while in contribution margin only variable cost have been deducted,

2) Contribution represents earning available for recovering fixed cost and required profit

If the contribution margin ratio is excessively low or negative, it would be unwise to continue selling a product at that price point, since the company would have considerable difficulty earning a profit over the long term.

On other way,

The contribution margin should be relatively high, since it must be sufficient to also cover fixed costs and administrative overhead.

Useful in planning

I) It will guide management in its pricing policies. The information on contribution margin ratio will guide management when or how to increase prices.

Ii) it determines company ability to meet its variable cost so that better planning can be made,

iii) it gives availabel amount for fixed expenses

3) margin of safety

MOS =Sales- Break even point

Margin of safety is excess sale made by company over its break even point so that profit can be earned,

It is amount at which company would able to earn profit,

4) margin of safety tell companies about how much more sale have done by it over it break even point so that safety of profit can be maintain,

At break even point no profit earned by compnay but above break even profit can be earned by it ,

Use of information

The information regarding margin of safety helps a company to take decision regarding how much more sale is needed,and how much safe in terms of sale and demand of product based on which appropriate budget of expenses can be made,

It also gives clear picture about how much company is safe to earn income in percentage term,