Contribution to sales ratio
Contribution to sales ratio is one of the most important tools used in profit management and for studying the profitability of operations of a business. It's called also profit/volume ratio or marginal ratio[1]. In the literature, as well as in practice, we often meet with abbreviations such as C/S ratio or P/V ratio.
The contribution to sales ratio is a measure of how much of each sales dollar is available to contribute to the recovery of fixed costs and the generation of profit. It is calculated by dividing the contribution margin (sales revenue minus variable costs) by total sales revenue. A higher contribution to sales ratio indicates a higher level of profitability for a company.
Formula
Contribution/sales (C/S) ratio = profit/volume (P/V) ratio = (contribution/sales) x 100%[2].
To understand the above formula, it is necessary to explain the concept of contribution. So, the contribution could be defined as the excess of sales over variable cost. It's a surplus which in the first instance is available to cover fixed costs and when fixed costs have been covered, as net profit[3].The ratio is expressed as a percentage and it furnishes the details of profitability of various products, processes or departments. A high C/S ratio shows that even a slight rise in the volume without a corresponding increase in fixed cost would result in high profit. That's why it's recommended for management to increase sales by taking appropriate actions such as advertising and other sales promotional measures. In the other way the C/S ratio could be increased by maximizing contribution. It's possible for example by selling price or reducing the variable cost, as well as by improving the product mix[4].
Example of calculation C/S ratio
We have the following data on sales and costs in company:
- Total sales: 500 000 USD
- Selling price per unit: US$100
- Variable cost per unit: US$60
- Fixed cost: 120 000 USD
From given information we could calculate C/S ratio[5]:
- C/S ratio = (contribution/sales) x 100%
- Contribution = sales - variable cost
- Sales in unit = 500 000/100 = 5 000 units
- Contribution = 500 000 - (5 000 x 60) = 500 000-300 000 = 200 000 USD
- C/S Ratio = 200 000/500 000 x 100% = 40%
The C/S ratio is a measure of how much contribution is earned from each US$1 of sales. The C/S ratio of 40% in this example means that for every US$1 of sales a contribution of 40c is earned.
Example of calculation average C/S ratio for multiple products
The company sells two products, product A and B. The organization expects to sell 1 product A for every product B. It is also known that product A has a C/S ratio of 20% whereas product B has a C/S ratio of 40%. From given information we could calculate average C/S ratio:
- Average C/S ratio = ((20% x 1) +(40% x 2))/3 = 33,33%
- The C/S ratio of 33,33% in this example means that for every US$1 of sales of the standard mix of products, a contribution of 33,33c is earned. To earn a total contribution of, say, 10 000 USD, sales revenue from the standard mix must therefore be: US$1/33,33c x 10 000 USD = 30 003 USD .
Benefits of contribution to sales ratio
There are several benefits of using the contribution to sales ratio:
- Identifying profitable products or services: The contribution to sales ratio can help a company identify which products or services are the most profitable, and therefore should be prioritized in terms of production and marketing.
- Identifying unprofitable products or services: The contribution to sales ratio can also help a company identify which products or services are not profitable, and therefore should be either eliminated or re-priced.
- Planning and budgeting: The contribution to sales ratio can be used in planning and budgeting, to help a company project how much sales revenue it needs to generate in order to cover its fixed costs and achieve a desired level of profit.
- Break-even point: The contribution to sales ratio can be used to calculate the break-even point, which is the point at which a company's total revenue equals its total costs. This helps the company determine how much it needs to sell in order to make a profit.
- Evaluating performance: The contribution to sales ratio can be used to evaluate the performance of a company over time, to see if the company is becoming more or less profitable.
Limitations of contribution to sales ratio
The contribution to sales ratio can be a useful tool for evaluating a company's profitability, but it also has some limitations:
- Limited perspective: The contribution to sales ratio only looks at the relationship between sales and variable costs, and does not take into account fixed costs or overall profitability.
- Does not take into account the volume of sales: The ratio only looks at the percentage of sales that contributes to profit, but does not take into account the total volume of sales.
- Does not account for long-term profitability: The ratio only looks at a single period, it does not account for long-term profitability, which may be affected by factors such as investments in research and development or future market trends.
- Does not account for external factors: The ratio does not take into account external factors such as competition or economic conditions that could affect the company's profitability.
- Not suitable for service industries: The ratio is not suitable for the service industry as it is hard to identify the variable costs and fixed costs.
It's important to consider these limitations and use the contribution to sales ratio in conjunction with other financial metrics to get a more complete picture of a company's financial health.
Footnotes
- ↑ Kumar A., Sharma R. (1998), Financial Management, Theory and Practise
- ↑ ACCA Paper F5 Performance Management (2012), BPP Learning Media
- ↑ Kotas R. (1999), Management Accounting for Hospitality and Tourism
- ↑ Rao T. (2006), Accounting and Financial Management for BCA & MCA
- ↑ Periasamy P. (2009), Financial Management
| Contribution to sales ratio — recommended articles |
| Contribution margin ratio — Combined Ratio — Return on sales — Sales mix — Return on net assets — Market growth — Bank efficiency ratio — Standard price — Direct costing |
References
- ACCA Paper F5 Performance Management (2012), BPP Learning Media
- Kotas R. (1999), Management Accounting for Hospitality and Tourism, International Thomson Business Press
- Kumar A., Sharma R. (1998), Financial Management, Theory and Practise, Atlantic Publishers and Distributors
- Periasamy P. (2011), Financial Management, Tata McGraw-Hill Education Private
- Rao T. (2006), Accounting and Financial Management for BCA & MCA, New Age International
Author: Sławomir Maciejowski
