Contribution margin ratio

Contribution margin ratio
See also

Contribution margin ratio measures the percentage of sales that would increase net income. It can be calculated by dividing the contribution margin by sales, either[1]:

  • in total
  • per unit.

The contribution margin ratio is most useful when the increase or decrease in sales volume is measured in sales dollars. In this case, the change in sales dollars multiplied by the contribution margin ratio equals the change in income from operations[2]. The contribution margin should be relatively high, as it should be sufficient to cover both fixed and operating overhead expenses. If the contribution margin ratio is excessively low or negative, continuing to sell a product at that price point would be unwise, as the company would have considerable difficulty in earning a long-term profit. Nevertheless, there are situations where it may be reasonable to sell a bundle of goods and/or services where there is a negative contribution margin for individual items in the package, as long as the contribution margin for the package is positive. The ratio is also useful in determining the revenue from different sales rates.

Formula of the Contribution Margin Ratio

The formula of the Contribution Margin Ratio is presented as [3]\[Contribution\ Margin\ Ratio\ =\ \frac{Total\ Sales\ Revenue - Total\ Costs}{Total\ Sales}\]

Contribution Margin Ratio in Strategies of Developing Business

Also useful in developing business strategies is the contribution margin ratio. Assume, for example, that a company has a high contribution margin ratio and produces less than 100 percent of capacity. In this scenario, from an increase in sales size, a significant increase in revenue from operations can be expected. The company could consider carrying out a special sales campaign to increase sales. On the other hand, a business with a low contribution margin ratio would likely want to pay more attention to cost management before trying to promote sales[4].

References

Footnotes

  1. M. P. Holtzman, 2013, p. 181
  2. J. Reeve, C. Warren, J. Duchac, 2011, p. 974
  3. K. Heisinger, 2009, p. 258
  4. J. Reeve, C. Warren, J. Duchac, 2011, p. 974

Author: Aleksandra Walawska