What is the contribution margin ratio?
The contribution margin ratio is a company's contribution margin (the value of its sales minus its variable costs) divided by sales revenue and expressed as a percentage.
In other words, the contribution margin is the money left over from sales after paying all direct costs associated with producing a product or service, such as paying for raw materials, packaging and shipping. The margin shows how much of total earnings are left to pay for fixed expenses like rent, utilities and profit generation.
By dividing the contribution margin by sales revenue, the contribution margin ratio provides a percentage that can be used to compare how much individual products or services contribute to a company's profit margin on a like-for-like basis, removing production levels and sales volumes from the equation.
How to calculate the contribution margin ratio
The contribution margin ratio formula takes the contribution margin and divides it by sales revenue:
Contribution Margin Ratio = Contribution Margin / Sales Revenue
Contribution margin
The contribution margin is calculated as follows:
Contribution Margin = Sales Revenue - Variable Costs
If the total contribution margin earned in a period exceeds the fixed costs for that period, the business will be in profit, says Matt Barton, Technical Manager at The Institute of Financial Accountants. However, if the total contribution margin is less than the fixed costs, the business will be making a loss. In this way, contribution margin shows your break-even point, or how much you need to make from sales to cover fixed costs and make a profit, adds Barton.
“Any profit-making business can benefit from contribution margin analysis, as it helps to identify any business’ break-even point, and inform pricing decisions,” he says.
Sales revenue
This is the total money your business earns in a specific period from selling its products or services. The period could be monthly, quarterly or annually.
Variable costs
Variable costs are those that change according to sales volumes and include items such as raw materials and shipping.
They differ from fixed costs that don’t change over time or with the number of goods you produce. For example, equipment, salaries, insurance and utilities.
Contribution margin ratio calculation example
Barton shares an example of how to use the contribution margin ratio formula in practice. Let’s start by looking at a simplified profit and loss statement for Company A.
| Sales revenue | 500,000 |
| Materials | (210,000) |
| Direct labour | (60,000) |
| Variable overheads | (30,000) |
| Fixed costs | (160,000) |
| Profit | 40,000 |
To calculate the contribution margin, deduct all the direct, variable costs involved in manufacturing Company A’s products from the sales revenue. Using the figures in the table above:
Contribution Margin: £500,000 - (£210,000 + £60,000 + £30,000) = £200,000
To convert this into the contribution ratio, take the contribution margin and divide it by sales revenue.
Contribution Margin Ratio: £200,000 / £500,000 = 40%
This means the company is making enough money to cover its fixed costs. You can see from the table that a profit of £40,000 was also generated, which is calculated by taking the contribution margin of £200,000 and deducting the fixed costs of £160,000. The benefit of expressing the contribution margin as a percentage is that it allows you to more easily compare which products are the most valuable to your business. Let’s explore this in more detail.
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How to use the contribution margin ratio
The contribution margin ratio can be used to compare and choose between the different products and services a business could provide using the same resources, says Barton. It can help a business identify the degree to which a company depends on a particular product or service and also calculate a potential increase in sales required to break even in a loss-making company.
“We use the contribution margin ratio to understand the profitability of our new products,” says Pierre van der Heyden, Founder of Purpose Bar, a London-based company that enables customers to design their snack bars. The ratio helps van der Heyden to understand how the costs involved in producing the bars impact revenue overall.
As well as comparing the profitability of new products, Purpose Bar also uses the ratio to analyse its delivery fees. “We understood that we would need to achieve greater scale and optimise our costs before offering free delivery to customers,” says van der Heyden.
To make free delivery viable, this would mean selling at least 20,000 bars per month. “When we reach that number, we will have enough volume to source our ingredients directly to the producers,” says van der Heyden.
The most important time to calculate contribution margin is when evaluating a new product or service, or when choosing between different products and services that could be provided with the same, finite resources, explains Barton. For example, a company could make three different products on one machine. Assuming factors such as demand and competition are equal, it should make the product with the highest contribution margin, as that’s the one that will generate the highest profit.
Barton adds that contribution margin can support you in determining the lowest possible price at which sales can be made while still breaking even. This informs decisions on pricing, including possible sales and discounts. It also supports decisions on capital expenditure. For example, purchasing a new machine might lower direct labour costs but increase fixed costs.
What is a good contribution margin ratio?
In general, the higher the contribution margin ratio, the better. But what is considered ‘good’ largely depends on your industry. For example, in sectors with high fixed costs, such as those with hefty capital investment or research and development expenditure, a higher contribution margin is needed to achieve viability.
What does a 50% contribution margin ratio mean?
A 50% contribution margin ratio means that half of your revenue covers variable costs, indicating moderate profitability.
“When considering contribution margin, it’s more important to consider a contribution in relation to a business' fixed costs, or to compare contribution margins between competing products or companies, than to look for a predetermined minimum percentage,” says Barton.
In theory, the best contribution margin ratio is 100%, but in practice most businesses will operate well below that.
“Calculating the contribution margin ratio is invaluable for forward-looking planning, budgeting and forecasting,” Barton concludes.
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