Contribution Margin Ratio (CM
Ratio):
Contents:

Definition

Formula

Example

Importance

Review Problem
The contribution
margin as a percentage of total sales is referred to as
contribution margin ratio (CM Ratio).
The following
formula is used to calculate contribution margin ratio (CM
ratio):
CM Ratio =
Contribution Margin / Sales
CM ratio is
extensively used in
costvolume profit (CVP) calculations.
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%
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
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 tradeoffs 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:
