The financials of a company are vital for the stability of the company. Would the contribution margin analysis help with establishing a way for the company to focus on profits? Explain.
A contribution margin analysis is not only helpful to assessing corporate profitability, but utterly necessary. The contribution margin is the difference between the sale price per unit and any variable costs associated with producing that unit. This, in turn, is a fundamental part of any break-even analysis, which determines the minimum number of units a company must sell to cover their costs and become profitable.
Knowing and understanding the contribution margin is vital to establishing a viable path to corporate profitability. First, however, it's important to define exactly what the contribution margin is. Most simply, it's the difference between the sales price of a given product or service and any variable costs associated with creating or marketing it. Variable costs are expenses that fluctuate based on the level of production output.
As an example, if 1,000 units have a variable cost of $13 per unit and will be sold for $27 per unit, the contribution margin is $14 per unit. If upping unit production to 2,000 units lowers the variable cost to $11 per unit, maintaining the original sale price will now yield an increased contribution margin of $16 per unit. This amount is then used to cover any fixed costs in the company, with the remainder being realized as profit.
The contribution margin divided by total sales revenue is called the contribution margin ratio and provides the company, in percentage terms, with the size of the margin relative to net sales. In the latter example above, the ratio equates to 59.25 percent, which is the amount of gross profit realized on each unit prior to factoring in fixed costs.
By then determining the fixed costs associated with operating the company, executives glean a very robust picture of the health of their company, including overall net profit margin. The contribution margin concept is critical to generating a break-even analysis, which measures the level of sales a company must reach to cover its initial investment. Therefore, without the comparison margin, no realistic discussion on corporate profitability can take place.
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