Contribution margin (CM) is a cost accounting concept that allows a company to determine the profitability of individual products (Investopedia, 2015). In short, it is equivalent to the revenue less the total variable cost (Horngren, Datar, & Rajan). The CM per unit measures the amount of each unit sold contributes to cover fixed costs and increasing profit and also considers what happens when sales and production increase by one unit. The firm benefits from revenue equal to the selling price, but it also incurs increased costs equal to the variable cost per unit. Fixed costs are unaffected by changes in volume, so they do not affect the incremental profit associated with selling …show more content…
It is equal to the CM per unit divided by the selling price (Jiambalvo, 2013). The CMR is an important financial metric to calculate the profit potential for a business firm. Generally, products which yield the greatest contribution margin ratio should be emphasized by the business firm (Peavler, 2015).
The contribution margin ratio increases when sales increase. For every $1 increase in sales, profits increase by the contribution margin ratio. CMR can be increase by increasing the final sales price of its products, increase sales and decrease its variable cost or a combination of all three. If a company makes these adjustments and finds that its contribution margin is still too low, decreasing its fixed costs should be considered (Carty, 2015).
Breakeven analysis is the process of finding the break-even point level of activity at which total revenues equal total of fixed and variable costs. Using the CM technique, CM must equal total fixed costs to achieve breakeven point (Weygandt, Kimmel, & Kieso, …show more content…
The formula is as similar to the breakeven analysis formula but what differs is that the zero profit is replaced with the target net income.
Indicator of risk
Margin of Safety (MOS)
The margin of safety is a measure of risk where it represents the amount of drop in sales which a company can tolerate (Accounting Explained, 2013). MOS is the margin between the actual sales and breakeven point. It denotes the level of safety that the firm enjoys before incurring losses. The higher the margin of safety, the lower the risk of not breaking even (Accounting for Management, 2014). In other words, MOS is the excess budgeted sales revenue over break-even sales (Bazley, Hancock, & Robinson, 2014).
Higher MOS allows the firm to have more freedom to experiment the effect on varying the cost and spending on the revenue earned. For example, management of the company can try to gain market shares from competitors by changing their selling price or increase advertising spending to improve sales (efinancemanagement.com, 2015).
Degree of Operating Leverage
Limitations of CVP