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The Importance of Contribution Margin and Target Profit for Business Planning and Decision Making

The Importance of Contribution Margin and Target Profit for Business Planning and Decision Making

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Business planning and decision-making are essential for any organization that wants to achieve its goals and objectives. One of the tools that can help managers and entrepreneurs in this process is the contribution margin and target profit analysis.

What is Contribution Margin?

The contribution margin is the difference between the revenue and the variable costs of a product or service. Variable costs are those costs that change with the level of output or sales, such as direct materials, direct labor, and sales commissions. The contribution margin shows how much each unit of a product or service contributes to covering the fixed costs and generating profit for the business. Fixed costs are those costs that do not change with the level of output or sales, such as rent, insurance, and administrative salaries.

The contribution margin can be calculated in two ways:

– Per unit: Contribution margin per unit = Selling price per unit – Variable cost per unit

– Ratio: Contribution margin ratio = Contribution margin per unit / Selling price per unit

 

What is Target Profit?

Target profit is the amount of profit that a business wants to achieve in a given period. It is usually based on the strategic goals and objectives of the business, such as increasing market share, expanding product lines, or entering new markets. Target profit can be expressed in absolute terms (such as $10,000) or in percentage terms (such as 10% of sales).

To calculate the target profit, a business needs to know its fixed costs, contribution margin per unit or ratio, and desired level of sales or output. There are two methods to calculate the target profit:

– Equation method: Target profit = (Fixed costs + Target profit) / Contribution margin ratio

– Contribution margin method: Target profit = (Fixed costs + Target profit) / Contribution margin per unit

 

Why are Contribution Margin and Target Profit Important?

 

Contribution margin and target profit are important for business planning and decision-making because they help managers and entrepreneurs to:

– Evaluate the profitability and performance of different products or services

– Determine the optimal selling price and sales volume for each product or service

– Analyze the impact of changes in costs, prices, or sales volume on profit

– Set realistic and achievable goals and budgets for each product or service

– Develop strategies and tactics to increase sales revenue and reduce costs

 

In conclusion, contribution margin and target profit are useful tools that can help businesses to plan and make decisions that will improve their profitability and performance. By understanding these concepts and applying them to their products or services, managers and entrepreneurs can make informed choices that will help them achieve their goals and objectives.

 

Enroll for an Executive Master’s MBA in Management Accounting and Finance at the Euclea Business School. Call +971501550591

 

Works Cited:

(1) Contribution Margin: Definition, Overview, and How To Calculate. https://www.investopedia.com/terms/c/contributionmargin.asp

(2) Contribution Margin: What It Is, How to Calculate It, and Why You Need It. https://hbr.org/2017/10/contribution-margin-what-it-is-how-to-calculate-it-and-why-you-need-it

(3) Target profit analysis – Accounting For Management. https://www.accountingformanagement.org/target-profit-analysis/

(4) How To Calculate Target Profit Formula | Indeed.com. https://www.indeed.com/career-advice/career-development/target-profit-formula

(5) Target profit definition — AccountingTools. https://www.accountingtools.com/articles/what-is-target-profit.html

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