Final answer:
The contribution margin ratio measures the relationship between contribution margin and sales revenue, which helps companies understand how much revenue is available for covering fixed expenses and profit. It is also used alongside marginal cost and revenue analysis to optimize production for profitability.
Step-by-step explanation:
The purpose of the contribution margin ratio is to measure the relationship between contribution margin and sales revenue. The contribution margin is calculated by subtracting variable expenses from sales revenue. This ratio is important because it tells a company how much of its sales revenue is available to cover its fixed expenses and to contribute to profit after variable expenses have been paid.
Understanding the contribution margin ratio is crucial for economic decision-making. A firm can use this ratio along with marginal cost and marginal revenue comparisons to determine if producing additional units contributes to profit. This involves looking at how the costs of producing one more unit (marginal cost) stack up against the revenue that one more unit will bring in (marginal revenue).
Furthermore, when we look at average cost and examine the firm's profit margin, it allows producers to understand whether current market prices allow for profitability. Expanding the equation for profit gives us insight into average profit and how changes in output impact profit margins.