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A company is said to be more efficient when it keeps the least inventory on hand to make the sales it does. The systems of the company must be so efficient that goods are available for sale as and when required and spend the least amount of time waiting in a warehouse. This is because […]
5 Reasons Why Fundamental Analysis Does Not Work In Forex?
Fundamental analysis is considered to be the holy grail of stock investors. Warren Buffet claims to have amassed his fortune thanks to it. People who consider him to be a role model swear by the effectiveness of this method. The media also cannot stop singing praises. However, ask any Forex trader whether they follow fundamental […]
How Team Performance Affects Valuation?
Sporting franchises are often said to be confused about what their objectives should be. One chain of thought believes that since they are businesses, their objectives should also be financial in nature. This means that their objectives should also be about profit maximization or wealth maximization. On the other hand, there is a different chain […]
How Reserve Requirements Work ?
Reserve requirements are one of the most important features of modern central banking. We hear about reserve requirements almost every day in the media. When central banks like the Fed change these requirements, it is said to have a huge impact on the markets. Liquidity worth billions of dollars is said to be either released […]
Embedded Options in Fixed income Securities
Options and derivatives are generally associated with equity securities. It is for this reason that most investors are not aware that they can also buy bonds with embedded options from the market. Options significantly change the risk profile of the bonds being issued. It is for this reason that bonds that have embedded options need […]
It begins with the same old way. Companies have to compute the contribution margin for each of their products. This is a possibility if a company has a couple of hundred products. If there are thousands of products, we may have to use the sales based approach mentioned in the end of this article.
So, for each of the products find the contribution margin and divide it by the selling costs, to derive the contribution margin ratio.
The next step is to find the relative weights of each of these products. The common way to do this is to estimate the relative proportion of sales that different products have. For instance, if for every 1 product A, we sell two product B’s, their ratio is 1:2. We will need a ratio of the sales of all the products. This is found out by going into the empirical sales data that the company has. On the other hand, we can also find out if the sales are expected to change in the future period and make adjustments in our ratio based on this expectation.
The final step is to calculate a weighted average. This is done by multiplying each contribution margin ratio of every item with its relative weight, adding all of them together and then dividing them by the total number of weights. The number we obtain is our multiproduct contribution margin.
Now, this calculation is completely based on our assumption about the relative weights of the sales. If the weights change too much, the contribution of the weights will also completely change. So we need to understand that if the proportion of sales is changing, our contribution margin is obsolete.
For large companies like Wal-Mart where there are thousands of products, the multiproduct contribution margin is calculated based on the sales dollars. Instead of finding contribution margin ratio for each item, one ratio is found out for increase in every sales dollar. This number is pretty accurate, if it is computed using the correct empirical estimates.
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