Contribution margin ratio is a calculation of how much revenue your business generates from selling its products or services, once the variable costs involved in producing and delivering them are paid. This can be a valuable tool for understanding how to price your products to ensure your business can pay its fixed costs, such as salaries and office rent, and still generate a profit.
What Is the Contribution Margin Ratio?
Before getting into what the contribution margin ratio is, it can be helpful to understand what the 'contribution margin' is.
Contribution margin refers to the difference between the sales revenue and the variable costs of a product or service, such as raw materials, packaging, and shipping. In other words, it’s the money left over after paying all variable costs associated with producing a product or service. The contribution margin shows how much of total earnings are left to pay for (or contribute to) fixed expenses, such as salaries, rent, and utilities.
If the total contribution margin earned in a period exceeds the fixed costs for that period, the business will make a profit. If the total contribution margin is less than the fixed costs, the business will show a loss. In this way, contribution margin becomes an important factor when calculating your break-even point, which is the point at which sales revenue and costs are exactly even ($0 profit). This, in turn, can help you make better informed pricing decisions, but break-even analysis won’t show how much you need to cover costs and make a profit.
While contribution margin is expressed in a dollar amount, the contribution margin ratio is the value of a company’s sales minus its variable costs, expressed as a percentage of sales. More specifically, this ratio shows what portion or percentage of each dollar of sales revenue is available to cover fixed costs and generate profit, giving companies a quick view of a product’s profitability after paying variable expenses. However, the contribution margin ratio won’t paint a complete picture of overall product or company profitability.
The contribution margin ratio can help businesses set prices, plan sales or discounts, and manage additional costs, like delivery fees.
How to Calculate the Contribution Margin Ratio
To calculate the contribution margin ratio, you first need to calculate the contribution margin. You can calculate the contribution margin as follows:
Contribution margin = Sales revenue – Variable costs
- Sales revenue is the total money your business earns in a specific period from selling its products or services.
- Variable costs are those that change with sales volumes and include items such as raw materials and shipping. They differ from fixed costs, which don’t change over time or because of the number of goods you produce; fixed costs may include equipment, salaries, insurance, and utilities.
Contribution Margin Ratio Formula
The formula for contribution margin ratio takes the contribution margin and divides it by sales revenue:
Contribution margin ratio = (Contribution margin / Sales revenue) x 100
Contribution Margin Ratio Calculation Example
Let’s look at an example of how to use the contribution margin ratio formula in practice. We’ll start with a simplified profit and loss statement for Company A.
Variable labor (e.g., hourly, not salaried, employees)
To calculate the contribution margin, we’ll deduct all the direct and variable costs involved in manufacturing Company A’s products from the sales revenue. Using the figures in the table above, the formula looks like this:
$500,000 – ($210,000 + $60,000 + $30,000) = $200,000
With a contribution margin of $200,000, the company is making enough money to cover its fixed costs of $160,000, with $40,000 left over in profit. To convert the contribution margin into the contribution margin ratio, we’ll divide the contribution margin by the sales revenue.
($200,000 / $500,000) x 100 = 40%
The benefit of expressing the contribution margin as a percentage is that it allows you to more easily compare which products are the most valuable to your business. Let’s explore this in more detail.
How to Use the Contribution Margin Ratio
As mentioned earlier, the contribution margin ratio can help businesses determine the lowest possible price at which sales can be made and still break even. This analysis can aid in setting prices, planning sales or discounts, and managing additional costs like delivery fees. For example, a company aspiring to offer free delivery should achieve a scale where such an offering doesn’t negatively impact profits.
But perhaps the most important time to calculate contribution margin ratio is when evaluating a new product or service, or when a company is choosing between different products and services that could be provided with the same, finite resources.
Say a company could make three different products on one machine. Assuming factors like demand and competition are equal, the company should make the product with the highest return relative to variable costs in order to maximize profits.
The ratio can also support decisions on capital expenditure. For example, it can help a company determine whether savings in variable costs, such as reducing labor costs by using a new machine, justify the increase in fixed costs. This assessment ensures investments contribute positively to the company’s financial health.
What Is a Good Contribution Margin Ratio?
In general, the higher the contribution margin ratio, the better. But what is considered “good” largely can depend on your industry. For example, in sectors with high fixed costs, such as those with hefty capital investments or sizable research and development expenditures, a higher contribution margin ratio may be needed to achieve viability.
In other words, it’s more important to consider your contribution margin ratio relative to your fixed costs, or to compare contribution margin ratios with those of competing products or companies, than it is to aim for a predetermined minimum percentage. That said, most businesses operate with contribution margin ratios well below 100%.
Contribution margin ratios can also be negative. This means total variable costs are higher than sales from that product, meaning you are losing money on every unit produced. In such circumstances, this can inform a host of different business decisions. Is it better to discontinue the product? Can costs be reduced? Does it make more sense to outsource production?
Should the product be viewed as more of a “loss leader” or a “marketing” expense? A premier fashion brand, for instance, might be losing money on accessories, but want to continue the products to flaunt their logo on bags, shoes, belts, and scarves – so the company might decide to switch to an outsourcer that could make the accessories at a more cost-effective rate.
The contribution margin ratio is just one of many important financial metrics used for making better informed business decisions. The ratio can help businesses choose a pricing strategy that makes sure sales cover variable costs, with enough left over to contribute to both fixed expenses and profits. It can also be an invaluable tool for deciding which products may have the highest profitability, particularly when those products use equivalent resources. In general, the higher the contribution margin ratio, the better, with negative numbers indicating a loss on every unit produced.
A version of this article was originally published on March 20, 2023.
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