contribution margin ratio

Contribution margin is one of the most important concepts in managerial accounting. It is used extensively in planning and decision making because it is much easier to use than absorption costing, especially as variables change in the planning process.

Contribution margin can be defined in a number of different ways. Contribution margin per unit is price less variable cost per unit. Total contribution margin is sales less total variable costs. These are the two definitions you will see most often for contribution margin. I like to define contribution margin as the amount from each unit that contributes to fixed cost and profit.

Let’s look back at the contribution margin income statement:

NoCMIS1tice that contribution margin less fixed cost is profit. In order to make a profit, total contribution margin must be greater than fixed costs. Once all of our fixed costs are paid for, any additional sales generate profit.

But how much profit? Each unit would generate profit equal to the contribution margin for that unit. If the contribution margin per unit is $10, then each additional unit sold would provide an additional $10 of profit.

Contribution margin is most often expressed as a monetary unit, but we can also express it as a percentage of price. This is called the contribution margin ratio. The contribution margin ratio tells us the percentage of each sales dollar that becomes contribution margin

Contribution margin ratio = contribution margin per unit / price

or

Contribution margin ratio = total contribution margin / sales

We can also look at variable cost as a ratio. The variable cost ratio tells us the percentage of each sales dollar that would go toward variable cost.

Variable cost ratio = variable cost per unit / price

or

Variable cost ratio = total variable cost / sales

As long as price and variable cost remain the same, these ratios will remain the same. It does not matter if the company sells 10 units or 1 million units, the percentage of each sale that becomes contribution margin or does to cover variable costs is the same.

Let’s look at an example to illustrate how to calculate contribution margin and these ratios.

Example #1

Hangout Limited, LLC sells one product priced at $40 per unit. The variable costs (direct materials, direct labor, variable overhead and variable selling) is $25 per unit. Calculate the contribution margin per unit, the contribution margin ratio and the variable cost ratio.

We know that contribution margin is price less variable cost. Therefore, contribution margin is:

$40 – $25 = $15

That means that for every unit we sell, $15 will go to cover fixed cost and profit. Once the fixed costs are paid, $15 per unit becomes profit.

Now calculate the ratios. We’ll start with the contribution margin ratio. Contribution margin ratio is contribution margin per unit divided by price per unit.

$15 / $40 = 37.5%

What does that mean? For every dollar of revenue the company brings in,  37.5% or 37.5 cents will become contribution margin. This also tells us that 37.5% of every sale is available to pay fixed costs or generate profit.

The variable cost ratio is variable cost per unit / price.

$25 / $40 = 62.5%

This tells us that for every unit sold, 62.5% will go to cover variable costs.

These ratios are important as we start to look at planning and decision making using contribution margin.

Related videos

Contribution Margin

Share This:


Related pages


owners equity is increased bycalculating employer payroll taxesdepreciation cost calculatortotal period cost under variable costingamortization table for bondsperpetual inventory journal entries exampleexamples of fixed expensescalculate gross wagesexample of closing entriesperpetual inventory fifoweighted average contribution margin per unithow to prepare a statement of retained earningsvariable cost examples in manufacturingbond computations straight line amortizationpohr accountingdifference between credited and debitedwhat are fixed expenses examplescontribution margin in dollarscalculate pv of annuitycompute the predetermined overhead rateending finished goods inventorypayroll tax expense journal entrycash basis accounting journal entriesentry for prepaid insuranceexamples of cash flow statements indirect methoddouble declining depreciation equationgeneral entries of accounts payableincome statement cost of goods manufacturedexample of closing entriesjournal entry for retirement of bondshow to calculate the ending inventoryhow to compute ending inventorycalculating depreciation with salvage valuedefine indirect materialwhat is the present value of an annuityhow to calculate fifo in accountingfixed cost per unit formuladepreciation cost per unitaging account receivablestraight line depreciation examplepricing decisions in management accountingannuity due charthow to calculate contribution margin per unitnormal balance for dividendsoffice supplies expense accountinggaap journal entriesjournal entry worksheet accountingbalancing accounts receivablededuction calculator payrollcogs includesrecord unearned revenuecalculate total overhead costaccount receivable journal entries adjusting entrieswhat is employer portion of payroll taxbank to book reconciliation formatbeginning inventory plus the cost of goods purchased equalsunadjusted trial balance exampleformula for contribution marginss wage basepayroll accrual journal entryvariable manufacturing overhead formulaweighted average calculator accountinghow to calculate depreciable coststraight line depreciation with no salvage valuemerchandise inventory adjusting entryamortize bond premiumwhat is controllable marginreserve accounting entriesadjusted trial balance closing entrieswhat is federal withholding taxdifferentiate between wholesaler and retailerdiscount on bonds payable balance sheetmanufacturing overhead rate calculatoraccrued wages balance sheetcost ratio calculatorretained earnings accounting definitionunearned subscription revenuegross pay per paycheck