Cryptocurrencies and Taxation
Taxation has a major impact on the return that any investment generates. This is the reason why it is important to understand the impact of taxation on cryptocurrencies. However, since cryptocurrencies are relatively new, there is considerable ambiguity regarding the taxability of cryptocurrencies. In this article, we will have a closer look at some of […]
Wholesale Financial Markets
The financial services industry can be divided into two sectors viz, the retail and the wholesale sector. On one hand, there is the retail sector, which provides a wide variety of deposit-taking and loan-related financial services to the common people. On the other hand, there is the wholesale sector that provides services to institutions. These […]
The Pitfalls of Overvaluation
It is often believed that the role of the investment banker is to sell the company for the highest price. The conventional belief is that the higher the price, the more successful the issue has been. However, over the years, the management of issuing companies, as well as investment bankers, have painfully discovered that a […]
Dividend Discount Model: Advantages
Dividend discount models are the first type of discounted cash flow models that we will study. The model simply discounts cash flows at a given rate just like any other DCF model. The difference lies in the fact that dividend discount models consider only “dividends” as being legitimate cash flows. Therefore, if a firm pays […]
Case Study of the Indian Banking and Financial Services Industry using Strategic Tools
Finance is like Oil to the Engine of the Indian Economy As finance is the grease and the oil that keeps the engine of any economy running, the BFSI sector assumes importance in this context. While the post independence era witnessed many large private banks that were either family or community run as well as […]
The contribution margin is created by rearranging the profit equation to provide the requisite details. The profit equation is as follows: Profit = Selling Price (x) – Variable Costs (x) – Total Fixed Costs
It can be rearranged as : Profit = (Selling Price – Variable Costs)x – Total Fixed costs.
The part that has been rearranged in the bracket i.e. selling price – variable costs has become widely known as the contribution margin.
The contribution margin as the name suggests is a contribution of every sale towards recovering the fixed costs. If we look at the equation carefully, we see that the total amount of fixed costs is the same. Thus each time we make a sale we get selling price – variable cost. This contributes towards recovering the fixed costs.
When all the fixed costs are recovered, we reach the breakeven point. Following the breakeven point, the contribution margin does not help in recovering the fixed costs, rather it contributes towards increasing the profit.
The contribution margin can be any number, like 25 or 33 or any other for that matter. Like always in accounting, until we put this number into some context it is not very useful. Consider the case of two products, one has a selling price of $50 and a contribution margin of $15. The other has a selling price of $100 and contribution margin of $25.
Now, if we paid attention to only the contribution margin, we would think that selling the second product is more profitable. But that is not the case. For the same level of sales i.e. $100, the first product gives a contribution of $30 whereas the second gives a contribution of $25 only.
To ensure that we make the right decisions, accountants use the contribution margin ratio. This is nothing but the contribution margin divided by selling price
Contribution Margin Ratio = Contribution Margin/Selling Price = (Selling Price – Variable Costs)/Selling Price
Numbers can be put into the above mentioned formula to get the contribution margin ratio:
For the first product: Contribution margin ratio = $15/$50 = 30%
For the second product: Contribution margin ratio = $25/$100 = 25%
The higher the contribution margin ratio, the faster the company will reach the breakeven point. Hence, companies should make an effort to sell high contribution products faster. The focus should be more but not exclusively on contribution margin ratio. This is because products with lower contribution margin sell faster and in higher volumes. Neglecting their sales completely can have adverse effects on the profitability.
Your email address will not be published. Required fields are marked *
