Contribution Margin Ratio Definition and Formula

The contribution margin is a financial metric calculated by taking the selling price of a product and subtracting the variable expenses that go toward making that product. When a business has a high unit contribution margin, it has relatively low total variable costs within its net sales formula. A high contribution margin allows a company to use gross profits to pay down its fixed expenses.

A business deals with two principal types of expenses in its day-to-day operations: fixed expenses and variable expenses.

• Fixed: Fixed expenses (also called fixed costs) are expenses unrelated to the number of units a company might manufacture. These include items like building rent, machinery, and property taxes.
• Variable: Variable expenses (or variable costs) rise and fall on a per-unit basis. These include labor costs, sales commissions, and the price of raw materials.

In a financial analysis, managers and accountants calculate the contribution margin using the following contribution margin formula:

contribution margin=sales revenue-variable costs

The contribution margin is not synonymous with net income; companies must also pay down their total fixed costs before assessing their net profit. The contribution margin formula only accounts for variable costs.

The contribution margin ratio, or CM ratio, is a financial ratio that compares the contribution margin to sales revenue. Calculate the contribution margin ratio via the following formula:

Contribution Margin Ratio = Contribution Margin / Sales

You can calculate a contribution margin ratio for individual unit sales or for total sales. Both calculations will arrive at the same ratio because total sales volume will be a simple multiple of individual unit sales.

A contribution margin analysis can provide many points of insight for a growing business. Companies use contribution margins and contribution margin ratios to determine:

1. 1. Break-even analysis: A business’s break-even point is when its profits equal its costs, which includes both fixed costs and variable costs. When the total revenue from the goods sold exceeds the cost of making those goods, the business achieves profitability.
2. 2. Cost-volume-profit analysis: A CVP analysis examines the role of business costs (both fixed and variable), price point, and total sales volume in a company’s overall operating income. You can use a contribution margin to begin your broader CVP analysis.
3. 3. Long-term payment schedules: Variable expenses like employee salaries and sales commissions must be paid on a week-to-week basis. Over time, a business must also pay down its fixed costs including real estate costs, equipment purchases, and annual taxes. A higher contribution margin means the business can expect more money to pay down its fixed costs. A low contribution margin means there may be very few funds to allocate toward long-term expenses. A negative contribution margin means the business is losing money on each sale. In such cases, the business will need to fundraise to generate cash flow or slash its variable costs. Other options include ramping up pricing or discontinuing a money-losing product line.
4. 4. Financial statements: If a business seeks outside investment or wishes to go public on a stock market, it must issue various financial statements that reveal the fiscal health of the business. Contribution margin ratios may be included in such statements.

All investments and investment strategies entail inherent risks and introduce the potential for financial loss or the depreciation of assets. The information presented in this article is for educational, informational, and referential purposes only. Consult a professional investment advisor before making any financial commitments.

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