The contribution margin is perhaps the more important parameter as it measures the
impact on profits of any change in sales. Shatabdi contribution margin of 61% means
that every rupee of additional sales will increase the pretax profits by 61 paisa. Equally
every rupee decline in sales will reduce pretax profits by 61 paisa. The traditional
financial ratio analysis does not provide this information at all. For example, if we were
to compute the ratio of PBT to Sales for Shatabdi, we would get 7612/61527 = 12%. An
investor will be grossly mistaken if he were to conclude from this ratio that profits will
rise only by 12 paisa for every rupee increase in sales.
The previous sections focused on the growth in demand for the industry and the firm.
Since an investor is ultimately interested only in the profits of the firm, the forecasted
demand growth has to be translated into earnings growth. The contribution analysis is
the most important tool available to the investor for this purpose. Two notes of caution
are, however, in order. First, this analysis is valid only as long as the existing capacity is
adequate to meet the forecasted demand growth. This is because if new capacity has to
be created, the cost structure (particularly the fixed costs) would change. Second, the
traditional accounting statements do not provide adequate information about variable and
fixed costs. The contribution margin, therefore, has to be assessed using the analyst’s
judgment about the cost structure.
Financial Analysis and Measures of Risk
Contribution analysis also leads to a measure of risk. Since an investor is ultimately
concerned with the profit, his perception of risk would be determined by the possible
variability in the profit. The variability in profits arises primarily because of variability
in sales. We then ask what will be the percentage change in profits if sales changes by
1%.
Let us see what happens to the PBT of Shatabdi Industries if its sales drop by 1% from its
current level:
Current
Level99% of
Current salesChange
(1% drop)
Sales 61527 60912 615
Less Variable expenses 24008 23768 240
Contribution 37519 37144 375
Less Operating fixed costs 27756 27756 0
Less Interest 2428 2428 0
Add Non operating surplus 277 277 0
Profit before tax 7612 7237 375The decrease in PBT from 7612 to 7237 represents a drop for 4.93% though the drop in
sales was only 1%. This amplification factor of 4.93 is known as the Degree of Total
Leverage (DTL) and measures the risk arising out of the sensitivity of profits to compute