What is the contribution margin ratio?
Definition of Contribution Margin
Companies often look at the minimum price at which a product can be sold to cover the basic fixed expenses of operating. Fixed expenses do not change with an increase or decrease in production. They include costs such as rent, property taxes, business insurance, and other expenses that the company pays regardless of whether it produces any units of the product for sale. This analysis of the lowest selling price is called “break-even analysis.”
One important component of this analysis is the contribution margin, also known as the unit contribution margin. 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 change with the level of units produced and include costs such as raw materials, packaging, and labor used in producing each unit. The result of this calculation shows the portion of sales revenue not consumed by variable costs that can be used to meet fixed costs, also known as the contribution margin.
A low contribution margin typically appears in companies that rely heavily on service operations, while a high contribution margin is prevalent in industrial companies that require expensive machinery and large production facilities. Contribution margin analysis also helps companies measure their operating leverage. Companies that sell products or services that generate higher profits with fewer fixed and variable costs have very good operating leverage.
Formula and Result
The contribution margin ratio is a formula that calculates the percentage of the contribution margin (fixed expenses or sales minus variable costs) relative to net revenue, expressed as a percentage. The answer to this equation shows the total percentage of sales revenue remaining to cover fixed expenses and profit after covering all variable costs of producing the product.
Calculating Contribution Margin and Ratio
To calculate the contribution margin ratio, you will first need to calculate the contribution margin. You can calculate the contribution margin in one of two ways. Contribution Margin = Net Sales Revenue – Variable Costs Contribution Margin = Fixed Expenses + Net Income
Use the following formula to calculate the contribution margin ratio: Contribution Margin Ratio = Contribution Margin / Sales Revenue
The contribution margin ratio can help companies calculate and set revenue targets for a particular product.
Example of Contribution Margin
Let’s say ABC Widgets produces and sells a single product at a retail price of $20 each. The company needs to pay the following fixed expenses each month: $18,000 for machinery, $12,000 for general office expenses, and $1,000 for loan interest.
The variable cost is $6, as the company pays $4 to manufacture each unit and $2 for labor used to create the unit.
These factors lead to a contribution margin of $14 per unit. This is calculated as follows: Contribution Margin = (Sales Revenue $20 – Total Variable Costs $6) = $14
This also leads to a contribution margin ratio of 14/20 or 70 percent. Through this calculation, ABC Widgets learns that 70 percent of every sale of the product is available to contribute towards covering the total fixed expenses it needs to cover each month as well as achieving its profit goal.
What is a Good Contribution Margin?
The higher the margin, the better. The higher a company’s contribution margin ratio, the more funds are available to cover the company’s fixed expenses or overhead.
A good contribution margin is entirely relative, depending on the nature of the company and its expense structure, and whether the company is competitive with its peers in the business.
Look at the contribution margin on a product or product line basis, and review the profitability of each product line. It may no longer make sense to sell products at the current price, and if the contribution margin is too low, it may be advisable to discontinue the entire product line. This strategy can help streamline operations and have a positive impact on the company’s overall contribution margin.
Questions
Repeated
How do you calculate the contribution margin? Contribution margin = (Sales revenue – Total variable costs)
What is the contribution margin ratio? The company’s contribution margin ratio is the total revenue of the company minus variable costs, divided by revenue.
Was this information helpful? Thank you for your feedback!
Sources: The Balance, Corporate Finance Institute
Source: https://www.thebalancemoney.com/contribution-margin-ratio-393478
Leave a Reply