Contribution Margin Ratio (CM Ratio):

Learning Objectives:

1. Define and explain contribution margin ratio.
2. Calculate CM ratio.
3. What is the importance and benefit of calculating CM ratio?

1. Definition of Contribution Margin Ratio

2. Formula

3. Calculation

4. Importance

5. Review Problems

Definition of Contribution Margin Ratio:

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

Formula of CM Ratio:

Formula or equation of CM ratio is as follows:

[ CM Ratio = Contribution Margin / Sales ]

This ratio is extensively used in cost-volume profit calculations.

Calculation / Computation of Contribution Margin Ratio:

Example:

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

According to above data of A. Q. Asem 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 A. Q. Asem CM ratio can also be calculated as follows:

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

= ($100 / $250) × 100

= 40%

Importance 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 A. Q. Asem 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 A. Q. Asem 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:

*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.

You may also be interested in other relevant articles:

• Contribution Margin and Basics of CVP Analysis
• Difference Between Gross Margin and Contribution Margin
• Cost volume profit (CVP) relationship in graphic form
• Contribution margin ratio (CM ratio)
• Importance of the contribution margin
• CVP consideration in choosing a cost structure
• Operating leverage--degree of operating leverage
• Assumptions of CVP analysis
• Break even point analysis
• Target profit analysis
• Margin of safety
• Sales mix and break even with multiple products
• Limitations of Cost Volume Profit Analysis

 

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