Question

1. Explain the concept of a contribution margin and describe how its different from gross margin. what is the significance of the contribution margin ratio, and how is the ratio used when planning business operations? Give examples!

Answer 1

What Is the Contribution Margin?
The contribution margin can be stated on a gross or per-unit basis. It represents the incremental money generated for each product/unit sold after deducting the variable portion of the firm's costs.

The contribution margin is computed as the selling price per unit, minus the variable cost per unit. Also known as dollar contribution per unit, the measure indicates how a particular product contributes to the overall profit of the company. It provides one way to show the profit potential of a particular product offered by a company and shows the portion of sales that helps to cover the company's fixed costs. Any remaining revenue left after covering fixed costs is the profit generated.

The Formula for Contribution Margin Is
The contribution margin is computed as the difference between the sale price of a product and the variable costs associated with its production and sales process.

Cotribution Margine = Sales - Variable Cost

Gross profit is your income or sales less cost of goods sold (COGS), which are all fixed costs (above the line on your income statement). Contribution margin analyzes sales less variable costs, such as commissions, supplies and other back office expenses (costs listed below the line on the income statement).

The contribution margin ratio is the difference between a company's sales and variable costs, expressed as a percentage. This ratio shows the amount of money available to cover fixed costs. ... You can see how much costs can affect profits for a company, and why it is important to keep costs low.

Contribution margine Ratio = Contribution margine / Sales

What Does the Contribution Margin Tell You?
The contribution margin is the foundation for break-even analysis used in the overall cost and sales price planning for products. The contribution margin helps to separate out the fixed cost and profit components coming from product sales and can be used to determine the selling price range of a product, the profit levels that can be expected from the sales, and structure sales commissions paid to sales team members, distributors or commission agents.

For example, if the price is $10 and the unit variable cost is $2, then the unit contribution margin is $8, and the contribution margin ratio is $8/$10 = 80%.

In above example if the fixed cost is $ 3,000 , the break even sales will be (3000/80%) = 3,750

and number of units should be sell to reach break even (3750/10) = 375 units