Understanding how to calculate contribution margin ratio
As a business owner, it’s critical to understand different financial metrics to assess the profitability of your company. Determining your profit margin by calculating the amount your sales revenue exceeds costs is fundamental to know if your business is making a profit. You can go further than recognizing your profit margin to discover how particular products affect your profit.
To find out which products are performing the best for your company, you should calculate the contribution margin and contribution margin ratio. These two metrics help you to decide which products should be kept or discontinued. Products with a positive contribution margin bring in enough money to cover its allocated share of fixed cost, such as rent.
It’s important for you to know how to calculate both the contribution margin and contribution margin ratio. In this article, we will discuss the key differences between the two financial metrics and also how to find out the contribution margin and contribution margin ratio for your company.
What is the contribution margin?
The contribution margin is when you deduct all connected variable costs from your product’s price, which results in the incremental profit earned for each unit. This shows whether your company can cover variable costs with revenue.
The amount that’s left over after the variable costs have been covered is the contribution margin and signifies the total earnings that are left to cover fixed expenses and to make a profit. The contribution margin is normally shown in monetary terms.
What is the contribution margin ratio?
Contribution margin ratio is the expression of the contribution margin in terms of a percentage of a price. Therefore, the contribution margin is shown in dollars and the contribution margin ratio is demonstrated as a percentage.
Your company will be able to determine the percentage of each unit sale that helps to cover your profit and variable costs by working out the contribution margin ratio.
How can your company use the contribution margin ratio?
You can decide which products your company should continue to stock and which ones to get rid of by analyzing the contribution margin ratio. You can also work out how sales commissions will be allocated depending on each product’s contribution margin ratio.
A product line with a negative contribution margin ratio will mean that your company loses money when it produces this product. You have the option of removing negative contribution margin ratio products from your company or raising the price to allow for a positive contribution margin.
Your company can use the contribution margin ratio to make operational decisions more straightforward. This is especially the case if you carry a lot of product lines. You can use the contribution margin ratio to find out whether your products break even. Products in your company break even when revenue is the same as expenses, so your company neither has a net profit nor a net loss.
Errors to look out for when calculating the contribution margin ratio
You need to have a firm understanding of what your company classifies as fixed and variable costs in order to accurately calculate the contribution margin ratio. Unfortunately, some costs aren’t easily classified and can cause issues when determining the contribution margin.
For instance, if you bought software to increase the production of your product on a temporary basis, this software can be classed as a variable cost since it’s required because production is higher. Additionally, the software can also be classified as a fixed cost because it’s been purchased only once and the price doesn’t change depending on the number of products.
You should avoid using the contribution margin ratio as the only financial metric to decide whether to continue to stock a product. Some companies automatically get rid of a product with a low or negative contribution margin. However, there could be products with a low contribution margin that don’t need a high level of support. These products may have no effect on fixed assets.
So, the product’s overall contribution to the company, variable costs and how much the fixed costs are affected by the product should all be taken into consideration before dropping a product. Lastly, products with a low or negative contribution margin can be grouped together with other products and sold as a package.
Contribution margin formula
Before calculating your contribution margin, you need to be clear about which costs are variable and which ones are fixed. Variable business costs are expenses that change according to the number of a product that is produced – for example, materials or sales commissions. Fixed business costs stay the same, irrespective of the number of products that are produced, for instance, insurance and property taxes.
The contribution margin formula is as follows:
- Contribution margin = revenue − variable costs.
Here’s an example: The price of a product is $10 and the unit variable cost is $2. The unit contribution margin is $8.
How to find the contribution margin ratio
To find the contribution margin ratio, divide the contribution margin by sales. The contribution margin ratio formula is:
- (Sales – variable expenses) ÷ Sales
The following are examples of the contribution margin ratio:
Example 1: The Sole Shoe Company sells work wear shoes to specialist industries. It sold $10,000 worth of shoes in its most recent period with variable costs of $4,000. The Sole Shoe Company has fixed expenses of $6,500, resulting in a loss of $500.
Variable expenses $4,000
Contribution margin $6,000
Fixed expenses $6,500
Net loss $500
The Sole Shoe Company’s contribution margin is $6,000. Therefore, the contribution margin ratio is 60%. The Sole Shoe Company will have to decrease its fixed expenses or increase its sales for it to break even.
Example 2: Headphones Today sells one set of headphones for $40. The variable costs, which include direct material, direct labor, and variable selling (per headphone unit) is $25.
The contribution margin is the price minus the variable costs.
Headphones Today’s contribution margin is $40 – $25 = $15.
For every set of headphones that Headphones Today sells, $15 will go towards their fixed costs.
To calculate Headphones Today’s contribution margin ratio we use the contribution margin per set of headphones and divide it by the price per set of headphones, which is $15 / $40 = 37.5%.
Headphones Today’s contribution margin ratio tells the company owner that, for every dollar of revenue a set of headphones makes, 37.5 cents or 37.5% is the contribution margin. The owner of Headphones Today can decide to either use this 37.5% contribution margin to pay fixed costs or to produce a profit.
Example 3: Beaver Enterprises sells home appliances. They have revenue of $50 million and have sold goods amounting to $20 million. Beaver Enterprises spends $5 million on public relations, $5 million delivering their home appliances and their fixed costs amount to $10 million.
Revenue $50 million
Goods sold $20 million
Public Relations $5 million
Product delivery $5 million
Fixed costs $10 million
Beaver Enterprises can find out their contribution margin and contribution margin ratio with the following calculation:
Contribution margin = $50 million – $20 million – $5 million – $5 million = $20 million
Contribution margin ratio = $20 million / $50 million = 40%
Total contribution margin formula
As well as calculating your contribution margin in monetary terms and percentages, you can also work out your company’s total contribution margin. The total contribution margin is the entire earnings available to pay for your fixed expenses and to generate a profit.
In other words, your total contribution margin tells you the amount of contribution margin that has been earned by your company as a whole. You can create a contribution margin income statement using your total contribution margin.
You can work out your total contribution margin using the following formula:
Total contribution margin = total sales – total variable costs
A useful way to work out your company’s overall profitability is by comparing your total contribution margin to your fixed costs.
Contribution margin ratio calculator
You may want to consider using an accountant to assist in the calculation of your company’s contribution margin ratio. Using an accountant has the following benefits:
- Save time – If you’re not familiar with accounting rules and how to classify some of your costs, learning what figures go where can be time-consuming. So, hiring an accountant to work out your contribution margin ratio can free up your time to get other things done in your business.
- Remove complexities – As acknowledged above, working out whether a cost is fixed or variable can be tricky. An accountant will remove the complexity from working out your contribution margin ratio. You can take the opportunity to work with your accountant to get a clearer understanding of different financial terms so that you’ll know more about your company’s finances.
- Save costs – Inaccurate calculations of your contribution margin ratio can result in your company making losses by keeping products that are not profitable. Alternatively, if your calculations mistakenly show that a product has a negative contribution margin ratio, your company could wrongly dispose of a profit-generating product. Hiring an accountant to ensure the accuracy of your contribution margin ratio can have a positive effect on your company’s bottom line.
However, if you’ve decided not to use an accountancy professional to calculate your contribution margin ratio, you’ll need a reliable way to ensure your figures are accurate. After you’ve identified your fixed and variable costs and understand how to work out your contribution margin ratio, you could use a calculator that is already repopulated with a formula.
Accounting For Management, Finance Formulas, and other accounting sites contain contribution margin ratio calculators that will help you to identify your contribution margin. A useful contribution margin ratio calculator will include the following fields:
- Selling price per unit.
- Variable cost of goods sold per unit.
- Variable non-manufacturing expenses per unit.
- Actual or projected units sold.
A fit for purpose contribution margin ratio calculator will also break down the results into the following metrics:
- Contribution margin per unit.
- Total contribution margin.
- Contribution margin ratio.
- Contribution margin percentage.
- Total sales revenue.
- Variable cost per unit.
- Total variable cost.
Whether you use the services of a professional accountant or choose to use an online calculator to work out your company’s contribution margin ratio, it’s important to have an understanding of how to calculate this valuable financial metric.
An associated complexity of understanding how to calculate your contribution margin ratio is properly allocating fixed and variable costs. Let Deputy take the guesswork out of one area of your business.
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