Chapter 5, Problem 1Q

To determine

Contribution Margin: It is a margin which shows the share of sales revenue which is not covered by variable cost of a company.

Contribution Margin ratio: Contribution margin ratio is the ratio of contribution margin to net sales revenue in terms of percentage.

: Contribution margin ratio and its uses in planning business operations.

Answer to Problem 1Q

Solution: A contribution margin is the amount available for coverage of fixed expenses of the business operations. When the contribution margin is expressed in percentage of sales, it is called a contribution margin ratio. It is helpful in fixing a price for a product and for analyzing the impacts of revenue at different level of unit sales.

Explanation of Solution

: In simple words, a contribution margin is the difference between the sales revenue and variable cost of the product. A contribution margin ratio represents the percentage of sales revenue for meeting the fixed expenses of business operations.

A company can predict or estimate its operating income based upon the contribution margin ratio. A negative or low contribution margin indicates low opportunity for making profit and high risk of loss. It helps in determining the amount available with the firm to pay off its fixed expenses. Further, managers can use contribution margin ratio to determine if there is a need to decrease the variable costs or if there is any unprofitable product that needs to be dropped so that the saved resources can be utilized for a better product.

For example, if the selling price per unit of a product is $10 and a variable expense per unit is $6, the contribution margin ratio will be:

  $\begin{array}{l}Contributionmarginratio=\frac{Contributionmarginperunit}{Sellingpriceperunit}\hfill \\ =\frac{\$4}{\$10}\hfill \\ =0.40or40\%\hfill \\ *Contributionmargin=Sellingpriceperunit–Variableexpensesperunit\hfill \\ =\$10-\$6\hfill \\ =\$4\hfill \end{array}$

Conclusion

: A contribution margin is computed by deducting the variable expenses from the sales revenue of the company. The contribution margin ratio is ascertained by dividing the contribution margin with sales revenue of the company. As the contribution margin is used for meeting the fixed expenses, hence, the higher the contribution margin ratio, there is a better chances that the company might make handsome income from operations.