Defining and Calculating Contribution Margin Ratio

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Contribution Margin

One of the key building blocks of a break-even analysis is contribution margin, also called dollar contribution per unit. This is calculated by subtracting variable cost per unit from the selling price per unit, and illuminates the portion of sales revenue that is not consumed by variable cost, and is available to satisfy fixed cost.

In cost-volume-profit analysis, a form of management accounting, contribution margin—the marginal profit per unit sale—is a useful quantity in carrying out various calculations, and can be used as a measure of operating leverage.

Typically, low contribution margins are prevalent in the labor-intensive tertiary sector while high contribution margins are prevalent in the capital-intensive industrial sector.

Contribution margin analysis is a measure of operating leverage; it measures how growth in sales translates to growth in profits.

Contribution Margin Ratio

The contribution margin ratio is the percentage of contribution margin to net sales. Said differently, it is the difference between a company's sales and variable expenses, expressed as a percentage. The margin in this equation represents to total earnings available to both cover fixed expenses and generate a profit.

Calculating the Contribution Margin Ratio

Use the following formula to calculate the contribution margin ratio:

Contribution Margin Ratio = Contribution Margin/Sales

Here is an example using break-even analysis:

Break-even point in units = Fixed Expenses/Price - Variable Expenses

Break-even point = $60,000/$2.00 - .80 = 50,000 units

In order to develop the contribution margin income statement, we have to convert breakeven in units to breakeven in dollars. We use the contribution margin ratio to do this. Using the same example, variable expenses of $0.80 are 40% of sales of $2.00 per unit ($0.80/$2.00).

To calculate breakeven in dollars, divide its fixed expenses by the contribution margin ratio of 60% ($60,000/.6 = $100,000). This means that the company has to make $100,000 in sales to breakeven.

The contribution margin ratio is an important financial metric to calculate the profit potential for a business firm. If the dollar amount of sales increases by one dollar, in this example, the contribution margin increases by 60 cents. Net operating income will also increase by 60 cents. Generally, products which yield the greatest contribution margin ratio should be emphasized by the business firm.

Examples

XYZ, Inc. has a contribution margin ratio of 30%. Net operating income will increase by 30 cents if sales increase by one dollar.

Consideration

Another way to use this concept is to calculate the contribution margin per unit. If a company sells product for $10 and the variable cost is $4, the contribution margin per unit is $6 ($10 - $4). Therefore, everytime the company sells a unit, there is $6 to contribute to fixed cost and profit.

Remember that contribution is not gross margin. The contribution calculation considers variable cost but does not consider fixed cost. 

Using the calculation for contribution margin, and the contribution margin ratio, helps business owners determine whether to keep or jettison certain aspects of the business.

For example, a positive contribution margin indicates that a product is contributing to fixed cost, even if it is still not contributing to profit. A negative contribution margin ratio indicates that the business is suffering from every unit it sells of this product.