Question

Explain the concept of a contribution margin and describe how it differs from gross margin. Also, what is the significance of the contribution margin ratio, and how is the ratio useful in planning business operations? Provide examples.

Answer 1

Solution

Contribution Margin is a concept which we relates with the concept of variable costing system. Contribution Margin is the margin or profit which an organisation expects from it sales after covering all variable costs whether they are variable production costs or not which in simple term means that Contribution Margin = Units Sold * (Sales Price per Unit - Variable Costs per Unit). Using the concept of the Contribution Margin is is better to analyse product wise Profitability level and the results to maje better decisions.

It is different from Gross Profit or Gross Margin because Gross Margin is a concept which only related itself with the production costs whether they are variable or fixed costs it ignores period costs in its calculation. Gross Margin = Sales Price per Unit - Cost of Goods Sold per Unit. While calculating Contribution Margin we usually do not take into account the fixed Manufacturing Cost whereas in the case of Fixed Manufacturing Costs is also a deciding factor so on one hand where Contribution Margin tells us about the profit analysis gross margin focuses in the concept of Direct production costs.

Contribution Margin Ratio is the expression of Contribution Margin in terms of percentage. It is of great significance for every organisation who is using the concept of Cost Volume Profit Analysis as it is an important tools which helps an organisation to decide how much it should sale either to make break even or to achieve a certain level of Profitability or how much the company has to do to cover it's portion of fixed cost and Variable Costs to make some Profit.

Talking further how it could help in business planning Operations. For it an example wii be the most lucrative way to understand

A company has to decide which project to take Either Project P or Project Q both having Fixed Costs of $ 400,000

Particulars	Project A	Project B
Contribution Margin per Unit	10	20
÷ Sales Price per Unit	20	80
Contribution Margin Ratio in %	50%	25%

Particulars	Project A	Project B
Fixed Costs	400,000	400,000
/ Contribution Margin Ratio	50%	25%
Break Even Point in Dollars	800,000	1,600,000

As the above Calculations make it clear that it is more profitable to do Project A because it is more profitable one.

This is the thing that Contribution Margin Ratio helps in to decide which is the more profitable alternative to go for which helps the business in taking a decision which is more beneficial which hels the business to make better planning for taking out its decision and operations in a much processed and phased manner.

In the example there were two alternatives bith having same fixed costs but Contribution Margin Ratio helps us to decide which project will take less Amount of sales to cover it's fixed Costs and make profit more early which is an important aspect for any organisation so this is how Contribution Margin Ratio helps in business planning and organisations break Even Analysis.