Contribution; P/V Ratio

Contribution Margin and Profit/Volume (P/V) Ratio

These two concepts are fundamental tools in cost-volume-profit (CVP) analysis, providing valuable insights into a business's profitability and operational efficiency.

1. Contribution Margin (or Gross Margin)

The contribution margin represents the amount of revenue remaining after covering all variable costs associated with producing and selling a product or service. It's the portion of sales revenue that contributes towards covering fixed costs and generating profit.

• Formula:

  Contribution = Selling Price per Unit - Variable Cost per Unit

• Alternative Formula:

  Contribution = Fixed Costs + Profit

• Explanation:

  The first formula highlights the per-unit contribution. The difference between the selling price and variable cost per unit shows how much each sale contributes to covering fixed costs and ultimately generating profit.

  The second formula expresses the total contribution needed to cover all fixed costs and achieve a desired profit level.

• Significance:

  The contribution margin is a crucial metric for understanding the profitability of individual products or services. A higher contribution margin indicates greater profitability potential. It also helps in pricing decisions, as it shows the impact of price changes on profitability.

2. Profit/Volume (P/V) Ratio

The Profit/Volume (P/V) ratio expresses the relationship between the contribution margin and sales revenue. It indicates the percentage of each sales rupee that is available to cover fixed costs and generate profit. It's also known as the Contribution/Sales Ratio.

• Formula:

  P/V Ratio = Contribution / Sales

• Alternative Formula:

  P/V Ratio = (Sales - Variable Costs) / Sales

• Explanation:

  The P/V ratio essentially converts the contribution margin into a percentage of sales. It shows how efficiently sales are being converted into contribution, which then goes towards covering fixed costs and generating profit.

• Significance:

  The P/V ratio is an important tool for:

  • Profitability Analysis: A higher P/V ratio indicates greater profitability. It allows management to compare the profitability of different products or services.

  • Product Mix Decisions: When a business sells multiple products, the P/V ratio helps determine which products are more profitable and should be prioritized. Products with higher P/V ratios contribute more to overall profit.

  • Break-Even Analysis: The P/V ratio is used in calculating the break-even point in sales revenue.

  • Target Profit Analysis: The P/V ratio can be used to determine the sales volume required to achieve a specific target profit.