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The contribution ratio is an important financial ratio within management accounting. It is used to represent the contribution margin in percentage terms, and plays an important role in cost volume profit analysis, which analyzes the relationship between cost, volume and profit. The contribution margin ratio is used internally within businesses and helps management make important financial and operational decisions in an effort to increase profits.
Contribution Margin Ratio Components
You can think of the contribution margin ratio as the percentage of sales needed to pay for fixed costs. Fixed costs do not fluctuate based on production, but remain constant every month. Sales and variable costs are the two components that make up the contribution margin ratio. Sales are the amount the company brings in from its business operations. Variable costs fluctuate as changes in the business occur. They are directly related to the production of a business. Common variable costs include utilities, shipping, raw materials, hourly wages and inventory.
Calculation
The formula for the contribution margin ratio is CM Ratio = Contribution Margin / Sales. Revenue minus variable expenses results in the contribution margin. For example, if the revenue of a company is $600,000, and the variable costs are $360,000, then the contribution margin is $240,000. Therefore, the contribution margin ratio is 40 percent ($240,000 / $600,000). You can also calculate the contribution margin per unit.
Importance
The contribution margin ratio is important because it shows the impact a change in sales will have on the contribution margin. For example, if a company has a contribution margin ratio of 60 percent, it means that the contribution margin increases $0.60 for every $1 increase in sales. Net income also increases by 60 percent if fixed costs remain the same. Companies use the contribution margin to quickly calculate how much a future increase in sales affects net income. Companies can analyze which of their products yields the highest contribution margin ratio and focus on that product to increase sales.
Contribution Margin Analysis
Contribution margin analysis allows management to determine if the company is likely to earn a profit when setting a product at a particular price. This process is called pricing at the margin. Contribution margin analysis especially benefits companies that already break even, meaning they can pay their fixed cost. Contribution margin analysis allows companies to know the break-even point of a product. Fixed costs divided by contribution margin equals the break-even point. For example, if a company manufacturers automobile tires and its fixed cost equal $3,000 per week and its contribution margin per tire is $30, the company needs to produce 100 tires per week to break even.
Contribution Margin Ratio ComponentsYou can think of the contribution margin ratio as the percentage of sales needed to pay for fixed costs. Fixed costs do not fluctuate based on production, but remain constant every month. Sales and variable costs are the two components that make up the contribution margin ratio. Sales are the amount the company brings in from its business operations. Variable costs fluctuate as changes in the business occur. They are directly related to the production of a business. Common variable costs include utilities, shipping, raw materials, hourly wages and inventory.
Calculation
The formula for the contribution margin ratio is CM Ratio = Contribution Margin / Sales. Revenue minus variable expenses results in the contribution margin. For example, if the revenue of a company is $600,000, and the variable costs are $360,000, then the contribution margin is $240,000. Therefore, the contribution margin ratio is 40 percent ($240,000 / $600,000). You can also calculate the contribution margin per unit.
Importance
The contribution margin ratio is important because it shows the impact a change in sales will have on the contribution margin. For example, if a company has a contribution margin ratio of 60 percent, it means that the contribution margin increases $0.60 for every $1 increase in sales. Net income also increases by 60 percent if fixed costs remain the same. Companies use the contribution margin to quickly calculate how much a future increase in sales affects net income. Companies can analyze which of their products yields the highest contribution margin ratio and focus on that product to increase sales.
Contribution Margin Analysis
Contribution margin analysis allows management to determine if the company is likely to earn a profit when setting a product at a particular price. This process is called pricing at the margin. Contribution margin analysis especially benefits companies that already break even, meaning they can pay their fixed cost. Contribution margin analysis allows companies to know the break-even point of a product. Fixed costs divided by contribution margin equals the break-even point. For example, if a company manufacturers automobile tires and its fixed cost equal $3,000 per week and its contribution margin per tire is $30, the company needs to produce 100 tires per week to break even.
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