Defining and Calculating Contribution Margin Ratio
Many companies use financial metrics, such as 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 percent 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 a product could sell for 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 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 – 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 – variable costs.
The contribution margin ratio can help companies calculate and set targets for the profit potential of a given product. For example, assume a company produces and sells one product at a retail price of $20 each. It needs to pay fixed costs each month of $18,000 for machinery, $12,000 for general office expenses, and loan interest of $1,000. 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, calculated as $20 sales income – $6 total variable costs = $14 contribution margin. It also results in a contribution margin ratio of $14/$20, or 70 percent. The company 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.