The contribution margin ratio is the difference between a company's sales and variable expenses, expressed as a percentage. The total margin generated by an entity represents the total earnings available to pay for fixed expenses and generate a profit. When used on an individual unit sale, the ratio expresses the proportion of profit generated on that specific sale.
The contribution margin should be relatively high, since it must be sufficient to also cover fixed expenses and administrative overhead. Also, the measure is useful for determining whether to allow a lower price in special pricing situations. If the contribution margin ratio is excessively low or negative, it would be unwise to continue selling a product at that price point, since the company would have considerable difficulty earning a profit over the long term. However, there are cases where it may be acceptable to sell a package of goods and/or services where individual items within the package have a negative contribution margin, as long as the contribution margin for the entire package is positive. The ratio is also useful for determining the profits that will arise from various sales levels (see the following example).
The contribution margin is also useful for determining the impact on profits of changes in sales. In particular, it can be used to estimate the decline in profits if sales drop, and so is a standard tool in the formulation of budgets.
To calculate the contribution margin ratio, divide the contribution margin by sales. The contribution margin is calculated by subtracting all variable expenses from sales. The formula is:
(Sales - Variable expenses) ÷ Sales = Contribution margin ratio
To calculate the contribution margin that is used in the numerator in the preceding calculation, subtract all variable expenses from sales.
For example, the Iverson Drum Company sells drum sets to high schools. In the most recent period, it sold $1,000,000 of drum sets that had related variable expenses of $400,000. Iverson had $660,000 of fixed expenses during the period, resulting in a loss of $60,000.
Iverson’s contribution margin ratio is 60%, so if it wants to break even, it needs to either reduce its fixed expenses by $60,000 or increase its sales by $100,000 (calculated as $60,000 loss divided by 60% contribution margin ratio).
A user of the contribution margin ratio should be aware of the following issue. This ratio does not account for the impact of a product on the bottleneck operation of a company. A low contribution margin may be entirely acceptable, as long as it requires little or no processing time by the bottleneck operation.
The contribution margin ratio is also known as the CM ratio and the contribution ratio.