Organizations rely on financial formulas, tables, and models to solve problems and make business decisions. Financial formulas are business signals that can be interpreted consistently regardless of the organization. That makes them useful as guidance for management about when to take action to maximize organizational performance. Although each formula provides valuable information in and of itself, formulas also act in concert to provide additional means to evaluate business performance and the impact of one financial indicator on another. Return on investment, called ROI, and contribution margin are two such forumulas that work together to measure the success of business activities.
Return on Investment
The financial statement impact of an individual business initiative can be measured by calculating the initiative's return on investment. The ROI determines the economic feasibility of an initiative by comparing its costs and future benefits. Financial models used to measure ROI include discounted payback, net present value, simple payback, economic monetary value and internal rate of return.
The difference between a product's sales and the variable expenses incurred to produce it is referred as the contribution margin. This formula is important in evaluating a current or potential sale or production of a product. It identifies the degree to which the sale of a specific number of units sold at a particular price will yield the financial resources necessary to cover the fixed costs of producing the products sold, as well as generate a profit.
Purpose of Contribution Margin
In that the contribution margin sheds light on the number of units that must be sold at a particular price to cover costs and yield a profit, the formula is useful for identifying alternative approaches in sales or production that yield the highest contribution margin. That helps to plan the optimum use of manufacturing capacity. As a result, the formula is used to determine whether the acceptance or rejection of a sale, the production or discontinuance of a product line, or the manufacture or purchase of a part most positively impacts a company's return on investment and net income.
Contribution Margin and ROI
Both the return on investment and the contribution margin are used to analyze financial performance. The higher the contribution margin the better, because a high contribution margin suggests an organization's ability to maximize its profit for each sales dollar earned. Profit margin affects an organization's overall return on investment, so the determination of the profit contribution made by a particular sale or product is critical in making business decisions that will enhance or improve the organization's overall return.
- Schaum's Quick Guide to Business Formulas: 201 Decision-making Tools for Business, Finance, and Accounting Students; Siegel et al.
- Managerial Accounting: Tools for Business Decision Making; Weygandt et al.