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Contribution Margin Ratio (CM Ratio):

Contents:

  1. Definition

  2. Formula

  3. Example

  4. Importance

  5. Review Problem

Definition:

The contribution margin as a percentage of total sales is referred to as contribution margin ratio (CM Ratio).

Formula:

The following formula is used to calculate contribution margin ratio (CM ratio):

CM Ratio = Contribution Margin / Sales

CM ratio is extensively used in cost-volume profit (CVP) calculations.

Example:

Consider the following contribution margin income statement of XYZ private Ltd. in which sales revenues, variable expenses, and contribution margin are expressed as percentage of sales.

Total Per Unit Percent of Sales
Sales (400 units) $100,000 $250 100%
Less variable expenses 60,000 150 60%
 


Contribution margin $40,000 $100 40%
   

Less fixed expenses 35,000    
 
   
Net operating income $5,000    
 
   


Calculate contribution margin ratio

According to above data of XYZ private Ltd. the computations are:

Contribution Margin Ratio = (Contribution Margin / Sales) 100

= ($40,000 / $100,000) 100

= 40%

In a company that has only one product such as XYZ private Ltd CM ratio can also be calculated as follows:

Contribution Margin Ratio = (Unit contribution margin / Unit selling price) 100

= ($100 / $250) 100

= 40%

Importance Uses of Contribution Margin Ratio:

The CM ratio is extremely useful since it shows how the contribution margin will be affected by a change in total sales. To illustrate notice that XYZ private Ltd has a CM ratio of 40%. This means that for each dollar increase in sales, total contribution margin will increase by 40 cents ($1 sales  CM ratio of 40%). Net operating income will also increase by 40 cents, assuming that fixed cost do not change.

The impact on net operating income of any given dollar change in total sales can be computed in seconds by simply applying the contribution margin ratio to the dollar change. For example if the XYZ private Ltd plans a $30,000 increase in sales during the coming month, the contribution margin should increase by $12,000 ($30,000 increased sales CM ratio of 40%). As we noted above, Net operating income will also increase by $12,000 if fixed cost do not change. This is verified by the following table:

  Sales Volume Percent of Sales
  Percent Expected Increase
Sales $100,000 $130,000 $30,000 10%
Less variable expenses 60,000 78,000 18,000 60%
 



Contribution margin 40,000 52,000 12,000 40%
Less fixed expenses 35,000 35,000 0
 


 
Net operating income 5,000 17,000* 12,000  
 


 

*Expected net operating income of $17,000 can also be calculated directly by using the following formula:

[P*= (Sales CM ratio) Fixed Cost]

P* = Profit

Review Problems:

Problem 1:

Sales = $5,000,000
CM = 0.40
Fixed cost = $1,600,000

Calculate Profit.

Solution:

P = (Sales CM ratio) Fixed Cost
P = ($5,000,000 0.4) $1,600,000
P = $2,000,000 $1,600,000
= $400,000

Problem 2:

A company has budgeted sales of $200,000, a profit of  $60,000 and fixed expenses of $40,000. Calculate contribution margin ratio.

Solution:

P = (Sales CM ratio) Fixed Cost
$60,000 = ($200,000 CM ratio) $40,000
$60,000 + $40,000 = ($200,000 CM ratio)
CM ratio = $100,000 / $200,000
= 0.5

Some managers prefer to work with the contribution margin ratio rather than the unit contribution margin. The CM ratio is particularly valuable in situations where trade-offs must be made between more dollar sales of one product versus more dollar sales of another. Generally speaking, when trying to increase sales, products that yield the greatest amount of contribution margin per dollar of sales should be emphasized.

Relevant Articles:

Contribution Margin
Contribution Margin Ratio (CM Ratio)
Contribution Margin Income Statement
Break-even Point Analysis
Target Profit Analysis
Margin of Safety (MOS)
Operating Leverage
Break even Analysis with Multiple Products
CVP Consideration in Cost Structure
Importance of Cost Volume Profit (CVP) Analysis

 

 

 

 

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Financial Accounting Topics


  Introduction to Accounting
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  Transactions and Accounting Equation
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Accounting for Bills of Exchange
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Final Accounts
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  Capital and Revenue Items
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  Valuation of Inventories
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  Accounts of Non-profit Making Organizations
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  Statement of Cash Flows
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  Accounting Ratios Analysis
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  Depreciation, Provisions and Reserves
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  Accounting Dictionary
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  Financial Calculators
 
 
 
Managerial Accounting Topics

  Financial Statements
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  Cost Volume Profit Relationship
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  Variable Costing System
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  Materials and Inventory Cost Control
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  Activity Based Costing System
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  Standard Costing and Variance Analysis
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  Balanced Scorecard
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  Capital Investment Analysis/Capital Budgeting
 
 

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