Retirement Basics: Roth IRA
Roth Individual Retirement Account (IRA) is a retirement account that has been named after Senator Roth, who played an instrumental role in bringing this retirement account into existence. The Roth IRA is the second most popular investment vehicle used in the United States of America, the first one being 401(k). The popularity of the Roth […]
Pension Obligation Bonds
Pension funds across the world are facing a significant financial crisis. This is because, for a very long time, they have been investing heavily in equities since the interest rates offered by debt funds were quite low. However, in the recent past, the equity markets have sharply declined. As a result, the asset values of […]
Cash Ratio – Meaning, Formula and Assumptions
The cash ratio is limited in its usefulness to investors and financial analysts. It is the least popular of the liquidity ratios and is used only when the company under question is under absolute duress. Only in desperate circumstances do situations arise where the company is not able to meet its short term obligations by […]
History of Accounting
One can never really understand a subject, unless they know where it came from. Therefore, a short history of the subject of accounting may be of interest to students of accounting. Here is a very brief history of how accounting evolved: Single Entry Accounting System Accounting is as old as financial transactions themselves. As soon […]
Merger Modelling: The Accretion/Dilution Analysis
Merger modeling requires creating many sub-models which enable decision making. The accretion/dilution analysis is one such sub-model. It is one of the most sought after skills in junior investment bankers who have commonly entrusted the task of creating financial models in major investment banking firms. In this article, we will have a closer look at […]
It begins with the same old way. Companies have to compute the contribution margin for each of their products. This is a possibility if a company has a couple of hundred products. If there are thousands of products, we may have to use the sales based approach mentioned in the end of this article.
So, for each of the products find the contribution margin and divide it by the selling costs, to derive the contribution margin ratio.
The next step is to find the relative weights of each of these products. The common way to do this is to estimate the relative proportion of sales that different products have. For instance, if for every 1 product A, we sell two product B’s, their ratio is 1:2. We will need a ratio of the sales of all the products. This is found out by going into the empirical sales data that the company has. On the other hand, we can also find out if the sales are expected to change in the future period and make adjustments in our ratio based on this expectation.
The final step is to calculate a weighted average. This is done by multiplying each contribution margin ratio of every item with its relative weight, adding all of them together and then dividing them by the total number of weights. The number we obtain is our multiproduct contribution margin.
Now, this calculation is completely based on our assumption about the relative weights of the sales. If the weights change too much, the contribution of the weights will also completely change. So we need to understand that if the proportion of sales is changing, our contribution margin is obsolete.
For large companies like Wal-Mart where there are thousands of products, the multiproduct contribution margin is calculated based on the sales dollars. Instead of finding contribution margin ratio for each item, one ratio is found out for increase in every sales dollar. This number is pretty accurate, if it is computed using the correct empirical estimates.
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