Contribution Margin Ratio: Assessing Profitability in Business

Contribution margin ratio can be defined as the difference between the sales of a business (or its revenue) and the variable expenses for a certain period of time. it is a term that is crucial for every manager to be aware of, but very few actually are. Managers often tend to leave understanding the contribution margin ratio for bookkeepers and accountants at the workplace. By leaving the bookkeepers and accountants to calculate contribution margin ratio, managers end up losing sight of valuable pieces of their business. To be able to understand a business, you have to pay attention to controlling the contribution margin ratio.

In this article, we will be looking at the contribution margin ratio meaning, understand how to calculate contribution ratio, look at its limitations, and much more.

Contribution margin ratio can be defined as the difference between the sales of a business (or its revenue) and the variable expenses for a certain period of time. As the term itself suggests, the contribution margin ratio is represented in percentage. Contribution margin ratio is helpful in determining whether or not you should lower your prices, particularly in cases of bulk orders. It also aids in figuring out how changes in sales are likely to impact the profits of a business. The period of time you take into account is, however, irrelevant if the sales and variable expenses happen to be from the same dates.

Also read: What is a current ratio

Now, let us take a look at how to calculate contribution margin ratio using a formula. To put it very simply, the contribution margin ratio formula is:

Contribution Margin Ratio = (Total Sales - Total Variable Expenses) / Total Sales

The contribution margin ratio, often referred to as the CM ratio, represents the portion of revenue remaining after subtracting all variable costs from the product's revenue. This ratio indicates the residual profits generated from each product sold. The formula compares the contribution margin to each unit's selling price to determine the specific costs associated with each product. As the incremental profit that is earned on every product sale can be found out from the ratio, the ratio provides you with important information that could aid you in decision-making situations related to, for example, product pricing in an appropriate manner to make sure that a minimum margin is being met with, and the business model remains sustainable.

Also read: What is the cash ratio

Before you calculate contribution margin ratio, it is also important for you to understand the difference between variable costs (or VC) and fixed costs (or FC).

• Variable costs: The variable costs can be defined as the expenses that are directly related to production. As per the production output within a certain period of time, the variable costs of a company fluctuate either upwards or downwards. These costs include raw material costs, or direct labour costs, for instance.
• Fixed costs: The fixed costs tend to remain relatively the same, no matter the production volume of a company at any period of time. These costs do not depend on the production volume, and will be incurred no matter the circumstances. For example, the rental expense of a company on its office space has to be paid every month, whether or not the company’s sales are thriving.

To calculate contribution margin ratio, you have to follow three steps:

1. The contribution margin has to be first calculated: Selling Price Per Unit - Variable Cost Per Unit).
2. You then have to divide the contribution margin by the Selling Price Per Unit.
3. Lastly, multiply the Resulting Ratio by 100 to convert the numbers into a percentage.

Also read: What is a Treynor Ratio

Every business should be striving to improve their contribution margin. Improving the contribution margin of your business means that you are spending less money on variable costs and are ensuring higher amounts of profits which can cover your fixed expenses, and as a result, increase the profit margin. However, the contribution margin formula has only two metrics - your variable costs, and the selling price per unit. Thus, here are the only two ways in which you could be boosting your contribution margin:

Reducing variable costs

By reducing the fluctuating costs, you can see a dramatic increase in your contribution margin. This gives you more money to spend on your fixed expenses, or to make a profit. The lower the overall costs of your business are, the more you end up gaining on every sale. Therefore, it is important to keep the variable costs as low as you can.

Some of the usual variable costs a company has may include certain types of marketing materials, labour, and shipping. There are several ways in which you can reduce such costs. For instance, by finding alternative service providers. But, please remember that you have to be careful when you are cutting costs because cutting down on the quality of your products could hurt your business sales and reputation.

Increase revenue

Another way to ensure that the contribution margin of your business is increased is to increase revenue on the products that are sold. By increasing revenue, you are effectively reducing the percentage of revenue that goes into paying the variable costs of the business.

However, to increase the revenue does not really mean to increase the selling prices every time. Before you introduce higher prices, you may invest in marketing, which will help sell more goods, thereby boosting revenue.

You may also look at several pricing methods for increasing the contribution margin without having to lose any of your existing customers. Sadly, increasing prices and spending more for marketing could also result in lower contribution margins if you are not very careful. For example, if you end up spending a lot on advertisements without any sales growth, you will end up with a lower contribution margin.

Also read: What is the quick ratio

Finance professionals use the contribution margin ratio for analysing the profitability of a company or a business. The contribution margin ratio is calculated often for coming up with a break-even analysis, which then aids the company in figuring out at what point in time a new business project is likely to generate enough sales to cover their costs.

Doing a break-even analysis helps financial planning and analysis (or FP&A) teams figure out the right sales prices for every product, the profitability that could come from each product, and the budget that needs to be allocated for every project.

Also read: What is an expense ratio

The best contribution margin ratio that is possible to achieve is 100%. However, such a scenario would imply that a business has zero variable costs, which is usually not very realistic for most of the industries. The higher a company aims its contribution margin ratio, the easier it becomes to cover the fixed costs, and aids in gaining more profits.

While a higher contribution margin ratio is surely impressive, you must also remember that businesses should not be sacrificing on the quality of products or services just for the sake of increasing the contribution margin ratio. It is important for you as part of a company to ensure that there is a balance, which is essential to keep investors as well as customers happy, and ensure long-term success for the company.

Also read: What are mutual fund ratios

To calculate contribution margin ratio is to help understand what choices and decisions to make for your business to grow further. But it is not the only metric that you have to track to be able to get a complete and accurate picture of the financial health of your business. There are certain drawbacks and limitations associated, some of which have been listed and explained below:

Misleading calculation possibility

A significant problem with the contribution margin ratio is the potential for expense misclassification. If variable costs are incorrectly labelled as fixed, it can lead to a distorted financial picture. This misclassification may cause the contribution margin ratio to appear lower than it actually is, giving the false impression that a product is underperforming in terms of profitability. Since the contribution margin ratio is crucial in assessing how effectively a product contributes to covering fixed costs and generating profit, it is essential to categorise expenses accurately. Failing to do so can result in misleading data, leading to decisions that may negatively impact your business’s overall performance.

Can negatively influence decisions

Although the contribution margin ratio is a valuable metric, it should not be the sole factor that guides your business decisions. Over-reliance on this ratio, particularly if it is based on flawed calculations, can lead to poor decision-making that vastly affects your company. For example, a product with a low contribution margin might still be highly profitable if it sells in large volumes and requires minimal effort or resources. On the other hand, a product with a high margin may not be as lucrative if it demands extensive operational input or has limited market appeal. Therefore, it is important to consider a broader range of factors and analyses when evaluating product lines. Depending solely on the contribution margin ratio could result in missed opportunities or misguided investments.

Not a direct representation of profits

The contribution margin ratio is, without a doubt, a helpful indicator. But, it is not a complete measure of profitability. It fails to account for various factors that can influence the success of a product or product line, such as internal processes, management efficiency, or technological advancements. As a result, the contribution margin ratio cannot provide a full picture of profitability, as it overlooks costs not directly related to production. Therefore, while it remains a valuable tool, it should be used in addition to and simultaneously with other financial metrics to gain a more accurate and a complete understanding of a product’s financial performance.

Let us suppose that you have been tasked to calculate contribution margin ratio of a company’s product. In this instance, the product had generated Rs. 100 crores in the year 2022, with 2 crore units having been sold, alongside Rs. 40 crores having been spent in variable costs.

Therefore,

• The product revenue is Rs. 100 crores
• The number of products that were sold is 2 crore
• The variable costs are Rs. 40 crores

The product revenue and the total number of products sold have to be divided to figure out the selling price per unit. In this case, it stands to be Rs. 50 per unit.

Now, you will have to calculate the variable cost for each unit, which you can determine by dividing the total number of products sold by the total variable costs that were incurred.

Which is,

Variable Cost per Unit = Rs. 40 crores / 2 crores = Rs. 20.

Now, there are two more steps that remain. First, you have to calculate the contribution margin per unit, which in this case is Rs. 30.

Now, Rs. 30 is the earnings that remain after the deduction of variable costs. To conclude, you will calculate the contribution margin ratio percentage of the product by dividing the contribution margin per unit by the selling price per unit; which gives you 60%.

The contribution margin ratio is not always going to be the complete and/or good indication of economic benefit for your business. However, it does help you in making some decisions regarding the expenses that are part of the day-to-day running of your company.

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