variable cost 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


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


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

what does manufacturing overhead includehow to calculate overhead rate per direct labor hourhow to find total fixed cost on a graphassuming that the company uses the perpetual inventory systemexamples of equity accountsjanitor salaryjournal entries depreciationfixed manufacturing overhead costsformula for retained earningsbad debt expense definitionformula total fixed costaccrual accounting entriescontra liabilitiesaccounts receivable income statementadjusting entry for accrued interestchanges in accounts receivablesbasic managerial accounting conceptscontribution margin percentage formulajournal entry for provision for income taxoverheads allocationfifo perpetual inventory exampleaging of accounts receivable formulahow to calculate payroll withholding taxescalculation of cost of goods manufacturedaccounting for allowance for doubtful accountsmanufacturing cogsis common stock a current liabilitypv of annuitydepreciation journal entries exampleswhat are closing entries and why are they necessarycalculating payroll taxes for employerswhich account would normally not require an adjusting entrybond accounting entriesnet income percentage formula accountingfix cost and variable cost examplesthe cost of a long term asset is expensedhow to compute contribution margin per unitweighted average contribution margin ratio formulagross pay equationhow to calculate ending inventory fiforeversing entries in accountingpresent value of a single sum calculatorstraight amortizationallowance method of accounting for bad debtsaccount receivable entriesavoidable cost definitionprepaid expenses balance sheetpayroll taxes calculatorwhat is fed withholding taxfederal tax calculator 2014 paycheckwage taxes calculatoraccounting equitionhow to calculate finished goods inventoryhow to calculate depreciation with salvage valueclosing entries and a post closing trial balancelifo cost of goods solddefine reconcile accountingindirect method of cash flow statementwyoming unemployment calculatorowners equity equationoverhead cost per unitmerchandise accounting definitionemployer portion of payroll taxes calculatoraccumulated depreciation normal balanceunearned income entrysale of fixed asset entryinventory journal entries examplesaccounts receivable in income statementcalculating cogsexpense payable journal entrystraight line depreciation method formulacall option accounting journal entriespayroll accounting entriesadjusting trial balance examplenet income percentage formula accounting