Company managers use a variety of tools to manage their operation. Company analysts spend time calculating the variable costs and contribution margin for each product their company makes. The company uses this knowledge to determine how each sale impacts the company's net income and financial results. The contribution margin and variable costs provide significant information for company management to use.
The variable costs incurred by a company refer to those costs that increase as production increases. Examples of variable costs include direct materials or royalties. The company pays royalty fees for each additional unit sold. The company calculates both the variable cost per unit and the total variable costs. The contribution margin refers to the amount of money each product sold adds to reduce fixed costs and increase profits. The company calculates the contribution by subtracting the variable costs from the revenues.
Break even analysis requires an understanding of the contribution margin and variable costs. This analysis serves the company by allowing the manager to plan for the year. The break even analysis calculates the minimum level of sales the company needs to achieve in order to pay all of its expenses for the year. The manager needs to evaluate its anticipated sales for the coming year and compare those sales to the break even sales. The manager then takes action if the anticipated sales are not enough to break even.
Cost recovery represents another significant use of the contribution margin and variable costs. Before recognizing a profit, the company needs to recover its variable and fixed costs. The contribution margin provides data regarding the money available after paying the variable costs. This money reduces the amount of fixed expenses. The company recovers the variable costs from the selling price of each unit. The company recovers the fixed costs from the contribution margin of each unit.
All companies strive to maximize profits. Profits deliver earnings to the owners of the company. After the company recovers its cost for doing business, it starts building its profit for the year. The contribution margin earned on these units starts building the company's profits. The company calculates the increase in profit by determining the contribution margin and multiplying this number times the units sold after all fixed costs have been recovered.
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