What is Contribution Margin Ratio?
The Contribution Margin Ratio is the product revenue remaining after deducting all variable costs, expressed on a per-unit basis.
How to Calculate Contribution Margin Ratio?
The difference between variable costs and fixed costs is as follows.
- Variable Costs (VC) → The incurred costs directly tied to and fluctuate based upon production volume (i.e. output activity) in the current period. Based on the production output in the given period, a company’s variable costs – such as direct labor and raw material costs – fluctuate either upward or downward, since such costs support the generation of revenue.
- Fixed Costs (FC) → These incurred costs remain relatively the same, regardless of the company’s production volume in the given period. Fixed costs are independent of production volume and are incurred regardless of the circumstances. For instance, a company’s rental expense on an office space must be paid each month, whether its sales are thriving or if the company is on the verge of bankruptcy.
The calculation of the contribution margin ratio is a three-step process.
- Calculate the Contribution Margin (Selling Price Per Unit – Variable Cost Per Unit)
- Divide the Contribution Margin by the Selling Price Per Unit
- Multiply the Resulting Ratio by 100 to Convert into Percentage Form
Contribution Margin Ratio Formula
The formula to calculate the contribution margin ratio (or CM ratio) is as follows.
The resulting ratio compares the contribution margin per unit to the selling price of each unit to understand the specific costs of a particular product.
Since the incremental profit earned on each product sale can be derived from the ratio, the ratio offers useful information that can help guide decisions, such as setting product pricing appropriately to ensure a minimum margin is met (and the business model is sustainable).
Contribution Margin Ratio Calculator
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
Contribution Margin Ratio Calculation Example
Suppose you’re tasked with calculating the contribution margin ratio of a company’s product.
In 2022, the product generated $1 billion in revenue, with 20 million units sold, alongside $400 million in variable costs.
- Product Revenue = $1 billion
- Number of Products Sold = 20 million
- Variable Costs = $400 million
The product revenue and number of products sold can be divided to determine the selling price per unit, which is $50.00 per product.
- Selling Price Per Unit = $1 billion ÷ $20 million = $50.00
In the next part, we must calculate the variable cost per unit, which we’ll determine by dividing the total number of products sold by the total variable costs incurred.
- Variable Cost Per Unit = $400 million ÷ 20 million = $20.00
Only two more steps remain in our quick exercise, starting with the calculation of the contribution margin per unit – the difference between the selling price per unit and variable cost per unit – which equals $30.00.
- Contribution Margin = $50.00 – $20.00 = $30.00
The $30.00 represents the earnings remaining after deducting variable costs (and is left over to cover fixed costs and more).
In conclusion, we’ll calculate the product’s contribution margin ratio (%) by dividing its contribution margin per unit by its selling price per unit, which returns a ratio of 0.60, or 60%.
- Contribution Margin Ratio (%) = $30.00 ÷ $50.00 = 60.0%