Many companies use financial metrics, such as the contribution margin and the contribution margin ratio, to help make decisions on whether to keep or discontinue selling various products and services. For example, if a company sells a certain product that has a positive contribution margin, the product is making enough money to cover its share of fixed costs, such as building rent, for the company.
However, the analysis might also show that the product is not earning enough to also cover its share of variable costs, such as direct labor and utilities, and generate a profit as well. The contribution margin ratio takes the analysis a step further to show the percentage of each unit sale that contributes to covering the company's variable costs and profit.
Defining the Contribution Margin
Companies often look at the minimum price at which a product could sell to cover basic, fixed expenses of the business. Fixed expenses, those that do not vary with an increase or decrease in production, include building rent, property taxes, business insurance, and other costs the company pays, regardless of whether it produces any units of product for sale. This minimum-sale-price analysis is called a break-even analysis.
One of the important pieces of this break-even analysis is the contribution margin, also called dollar contribution per unit. Analysts calculate the contribution margin by first finding the variable cost per unit sold and subtracting it from the selling price per unit.
Variable costs fluctuate with the level of units produced and include expenses such as raw materials, packaging, and the labor used to produce each unit. The result of this calculation shows the part of sales revenue that is not consumed by variable costs and is available to satisfy fixed costs, also known as the contribution margin.
Typically, low contribution margins turn up in labor-intensive service businesses, while high contribution margins are prevalent in more capital-intensive industrial businesses that require costly machinery and large production facilities. Contribution margin analysis also helps companies measure their operating leverage. Companies that sell products or services that generate higher profit with lower fixed and variable costs have very good operating leverage.
The Formula and Result
The contribution margin ratio is a formula that calculates the percentage of contribution margin (fixed expenses, or sales minus variable expenses) relative to net sales, put into percentage terms. The answer to this equation shows the total percentage of sales income remaining to cover fixed expenses and profit after covering all variable costs of producing a product.
Calculating the Ratio
Use the following formula to calculate the contribution margin ratio:
Contribution margin ratio = contribution margin / sales
(where contribution margin = sales minus variable costs).
The contribution margin ratio can help companies calculate and set targets for the profit potential of a given product.
An Example of a Contribution Margin
Assume that ABC Widgets produces and sells one product at a retail price of $20 each. It needs to pay the following fixed costs each month:
- $18,000 for machinery
- $12,000 for general office expenses
- $1,000 for loan interest
For variable costs, the company pays $4 to manufacture each unit and $2 labor per unit.
These factors result in a contribution margin of $14 per unit. The calculation is as follows:
Contribution margin = ($20 sales income - $6 total variable costs) = $14
It also results in a contribution margin ratio of $14/$20, or 70 percent. From this calculation, ABC Widgets learns that 70 percent of each product sale is available to contribute toward the $31,000 of total fixed expenses it needs to cover each month and also help achieve its profit target.
What Is a Good Contribution Margin?
The higher the margin, the better—and in a perfect world, your contribution margin would be 100 percent. The higher your company's ratio result, the more money it has available to cover the company's fixed costs or overhead.
Most likely, however, the contribution margin will come in at much less than 100 percent, and maybe even less than 50 percent. In reality, a "good" contribution margin is all relative, depending on the nature of a given company, its expense structure, and whether the company is competitive with its business peers.
Look at the contribution margin on a per-product or product-line basis, and review the profitability of each product line. Selling products at the current price may no longer make sense, and if the contribution margin is very low, it may be worth discontinuing the product line altogether. This strategy can streamline operations and have a positive impact on a firm's overall contribution margin.