Why is contribution margin ratio important

In short, a contribution margin analysis helps a company figure out how to reach its profitability goals. Helen Akers specializes in business and technology topics. She has professional experience in business-to-business sales, technical support, and management.

Share on Facebook. Contribution Margin Basics A company can calculate an overall contribution margin and a contribution margin per unit. Selling Price and Volume The contribution margin often helps a company decide whether it should manipulate its selling price and sales volume. The ratio is also useful for determining the profits that will arise from various sales levels see the following example.

The contribution margin is also useful for determining the impact on profits of changes in sales. In particular, it can be used to estimate the decline in profits if sales drop, and so is a standard tool in the formulation of budgets.

To calculate the contribution margin ratio, divide the contribution margin by sales. The contribution margin is calculated by subtracting all variable expenses from sales. The formula is:. For example, if a company sells a certain product that has a positive contribution margin, the product is making enough money to cover its share of fixed costs, such as building rent, for the company. However, the analysis might also show that the product is not earning enough to also cover its share of variable costs , such as direct labor and utilities, and generate a profit as well.

The contribution margin ratio takes the analysis a step further to show the percentage of each unit sale that contributes to covering the company's variable costs and profit.

Companies often look at the minimum price at which a product could sell to cover basic, fixed expenses of the business. Fixed expenses , those that do not vary with an increase or decrease in production, include building rent, property taxes, business insurance, and other costs the company pays, regardless of whether it produces any units of product for sale.

This minimum-sale-price analysis is called a break-even analysis. One of the important pieces of this break-even analysis is the contribution margin , also called dollar contribution per unit. Analysts calculate the contribution margin by first finding the variable cost per unit sold and subtracting it from the selling price per unit. Variable costs fluctuate with the level of units produced and include expenses such as raw materials, packaging, and the labor used to produce each unit.

The result of this calculation shows the part of sales revenue that is not consumed by variable costs and is available to satisfy fixed costs, also known as the contribution margin. Typically, low contribution margins turn up in labor-intensive service businesses, while high contribution margins are prevalent in more capital-intensive industrial businesses that require costly machinery and large production facilities.

Contribution margin analysis also helps companies measure their operating leverage. Your contribution margin could be dramatically different because of how these costs are categorized. Another mistake that some managers make is to assume that you should cut the lowest-contribution-margin products. Looking at contribution margin in a vacuum is only going to give you so much information.

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