Cost-Volume-Profit analysis | Contribution Margin | Ratio

The cost-volume-profit analysis is the systematic examination of the relationship between selling prices, sales, production volumes, costs, expenses and profits. This analysis provides very useful information for decision-making in the management of a company. For example, the analysis can be used in establishing sales prices, in the product mix selection to sell, in the decision to choose marketing strategies, and in the analysis of the impact on profits by changes in costs. In the current environment of business, a business administration must act and take decisions in a fast and accurate manner. As a result, the importance of cost-volume-profit is still increasing as time passes.

CONTRIBUTION MARGIN

A relationship between the cost, volume and profit is the contribution margin. El margen de contribucion es el exceso de ingresos por ventas sobre los costos variables. The contribution margin is the revenue excess from sales over variable costs. The concept of contribution margin is particularly useful in the planning of business because it gives an insight into the potential profits that can generate a business. The following chart includes the income statement of the company Fusion, Inc. which has been prepared to show its contribution margin:

Sales	$1,000,000
(-) Variable Costs	600,000
= Contribution margin	$400,000
(-) Fixed Costs	300,000
= Income from Operations	$100,000

CONTRIBUTION MARGIN RATIO

The margin contribution can also be expressed as a percentage. The contribution margin ratio, which is sometimes called the profit-volume ratio, indicates the percentage of each sales dollar available to cover fixed costs and to provide operating revenue. For the company Fusion, Inc. the contribution margin ratio is 40%, which is computed as follows:

Sales - Variable Costs Contribution margin ratio = --------------------------
Sales

Contribution margin ratio = ($1,000,000 - $600,000) / $1,000,000 = 40%

The contribution margin ratio measures the effect on operating income of an increase or a decrease in sales volume. For example, assume that the management of Fusion, Inc. is studying the effect of adding $80,000 in sales orders. Multiplying the contribution margin ratio (40%) by the change in sales volume ($80,000) indicates that operating income will increase $32,000 if additional orders are obtained. To validate this analysis the table below shows the income statement of the company including additional orders:

Sales	$1,080,000
(-) Variable Costs ($1,080,000 X 60%)	648,000
Contribution margin ($1,080,000 X 40%)	$432,000
(-) Fixed Costs	300,000
Income from Operations	$132,000

Variable costs as a percentage of sales are equal to 100% minus the contribution margin ratio. Thus, in the above income statement, the variable costs are 60% (100% - 40%) of sales, or $648,000 ($1'080,000 X 60%). The total contribution margin $432,000, can also be computed directly by multiplying the sales by the contribution margin ratio ($1'080,000 X 40%).

UNIT CONTRIBUTION MARGIN

The unit contribution margin is also useful to analize the profit potential of proposed projects. The unit contribution margin is the dollars from each unit of sales available to cover the fixed costs of operation and provide operating profits. For example, if Fusion, Inc.'s unit selling price is $20 and its unit variable cost is $12, the unit contribution margin is $8 ($20 - $12).
The contribution margin percentage is most useful when the increase or decrease in sales volume is measured in sales dollars. To illustrate, assume that the company Fusion, Inc. sold 50,000 units. Its operating income is $100,000, as shown in the following contribution margin income statement:

Sales (50.000 units X $20)	$1,000,000
(-) Variable Costs (50,000 X $12)	600,000
Contribution Margin (50,000 units X $8)	$ 400,000
(-) Fixed Costs	300,000
Income from operations	$100,000

If sales of the company Fusion, Inc. could be increased by 15,000 units from 50,000 to 65,000 units, its operating income would increased by $120,000 (15000 units X $8), as shown below:

Sales (65,000 units X $20)	$1,300,000
(-) Variable Costs (65,000 units X $12)	780,000
Contribution margin (65,000 X $8)	$520,000
(-) Fixed Costs	300,000
Income from operations	$220,000