Contribution margin ratio definition
/What is the Contribution Margin Ratio?
The contribution margin ratio is the percentage of sales revenue that remains after deducting variable costs. It is calculated as contribution margin divided by total sales, or equivalently, one minus the variable cost ratio. The ratio indicates how much of each sales dollar is available to cover fixed costs and generate profit. A higher contribution margin ratio means the company reaches its break-even point more quickly and earns profit more rapidly as sales increase. Managers use this ratio for pricing decisions, cost control analysis, and evaluating the financial impact of changes in sales volume.
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How to Calculate the Contribution Margin Ratio
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.
Example of the Contribution Margin Ratio
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).
When to Use the Contribution Margin Ratio
The contribution margin ratio is most useful when a business wants to assess how efficiently it can cover fixed costs and generate profit from sales. It is especially valuable for evaluating the impact of changes in sales volume on overall profitability. This ratio is commonly used in break-even analysis, pricing decisions, and forecasting. When launching a new product, managing costs, or analyzing performance across products or departments, the ratio helps to determine which offerings are most profitable. It also supports short-term decision-making by focusing on variable costs and showing how much revenue remains to contribute to fixed costs and profit.
Problems with the 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.
Terms Similar to the Contribution Margin Ratio
The contribution margin ratio is also known as the CM ratio and the contribution ratio.
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How to Calculate Contribution Margin