What is the contribution margin ratio?

What is the contribution margin?

To understand the contribution margin ratio, it helps to first understand the contribution margin, which is the difference between the total variable costs of producing a good or service (like materials and hourly labor) and the revenue generated from selling it.

Put another way, the contribution margin is the portion of sales revenue left over after the cost of production that can go toward other, fixed expenses—think utilities, rent, and salaries. If the contribution margin is larger than fixed costs in a given period, the business will turn a profit during that period. A negative contribution margin, on the other hand, means a company is losing money on every sale.

The contribution margin is different from gross margin (or gross profit margin when expressed as a percentage), which is the difference between total revenue and the cost of goods sold (COGS).

How to calculate the contribution margin  

To calculate the contribution margin, subtract variable expenses from sales revenue:

Contribution margin = sales revenue - variable costs

Make sure you have a clear idea of fixed versus variable costs before you do your calculation.

Variable costs change based on volume of production and include:

• Raw materials
• Production supplies
• Packaging
• Transaction fees, like credit card fees
• Direct labor
• Shipping  

Fixed expenses do not vary based on production and include:

• Rent
• Utilities
• Salaries
• Insurance
• Loan repayments

The contribution margin is expressed in absolute terms—in dollars or other currency—but it can also be helpful to review the contribution margin as a percentage of sales, as a ratio, to make certain business decisions and assess how product costs and pricing stand to impact a company’s profitability. More on this below.

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How to calculate the Contribution Margin Ratio (CMR)

To calculate the contribution margin ratio, also known as CMR or CM ratio, divide the contribution margin by sales for the product in question and multiply by 100. 

Contribution margin ratio = (Contribution margin/sales revenue) x 100

Or written another way as the following formula:

Contribution margin ratio = ((Sales revenue - variable costs)/sales revenue) x 100

Example contribution margin ratio calculation

To use the contribution margin ratio formula in practice, let’s explore a simple example based on hypothetical business metrics.

Say we’re doing a contribution margin analysis on a bagel shop. Taking a look at the business owner’s cash flow, they earn $1,000,000 per year from bagel sales. Their variable costs are $550,000 per year spent on inputs like flour, eggs, cream cheese, seasoning, hourly labor, and other variable costs associated with sales. They spend another $200,000 per year leasing a store, paying utilities and insurance, and covering additional fixed costs.

Here’s the breakdown of how they’d calculate the contribution margin ratio:

Revenue from product sales: $1,000,000

Variable costs including hourly labor and materials: $550,000

Fixed costs including rent and utilities: $200,000

Total contribution margin = sales revenue - variable costs = ($1,000,000 - $550,000) = $450,000

Contribution margin ratio = (Contribution margin/sales revenue) x 100 = 450,000/1,000,000 x 100 = 45%

Using the CMR, this bagel shop business owner can now see that 45% of every dollar of sales is available to cover fixed costs and generate profit. That allows them to conduct financial analysis for decision-making purposes with regard to pricing, per-unit costs, and other factors that influence the profitability of any particular product.

How to use the contribution margin ratio in business 

The contribution margin ratio tells you what’s left of every dollar of revenue after variable costs to cover fixed costs and generate a profit. With that in mind, it can be a good way to assess business fundamentals, strategize around pricing, and allocate resources. Here are some examples of how the CMR can help:

To reach profitability

You can use the CMR to get a sense of what kind of scale you’ll need—how many units you’ll need to sell—in order to reach profitability. Generally speaking, a higher contribution margin ratio is more desirable to achieve profitability.

• A high contribution margin ratio indicates that a product is more profitable and cost efficient, and that a larger share of every dollar of revenue can be used toward fixed costs and profit. If your fixed costs are relatively low, a high CMR may mean that you have a quicker, lower-volume path to profitability. 
• A low contribution margin ratio indicates that there is less revenue to cover fixed costs and generate a profit per dollar of sales. Depending on your fixed costs, it may indicate that a higher volume of sales is required to turn a profit. That is not necessarily a bad thing if, for instance, you are looking to achieve profitability by selling a very high volume of goods at the lowest possible price.

To find your break-even point and profit

Your break-even point is the amount at which sales revenue covers fixed and variable costs. Of course, the goal is usually to pass the break-even point and turn a profit, but in order to do that, you need to price your product appropriately.

The contribution margin ratio can help you find the minimum sales price at which you’ll break even. Then, in order to profit, you may find that you need to raise prices to cover variable costs, or reduce costs to increase your contribution margin. Which route you choose depends on a host of factors, including the competitive landscape and demand for your product. 

Example break-even analysis:

If you’re selling a product for $100, with variable costs of $60 per unit, you can find your break-even point by calculating the contribution margin and then dividing it by fixed costs:

• Contribution Margin (CM): $100 - $60 = $40.
• CMR: $40 / $100 = 40%.
• Fixed costs: $10,000
• Break-even point: $10,000/$40 = 250

In this example, $40 from each sale is on hand to cover fixed costs and contribute to net profit. If fixed costs total $10,000, you need to sell 250 units to break even. You’d have to determine whether that’s an achievable sales goal at your price point, and if not, adjust your price point, cost structure, or both in order to surpass it.

To plan promotion and sales strategies

In addition to optimizing your selling price to move beyond the break-even point, the contribution margin ratio can help you plan for other pricing and marketing initiatives like promotions and discounts. Knowledge of your break-even point tells you the absolute minimum price at which you’d want to offer your product to avoid negatively impacting your bottom line. That allows you to price promotions so that they help you reach your profitability goals.

To allocate resources and investment

If you sell more than one product and have limited resources on hand (a fixed quantity of factory space, for example, or a limit on the number of people you can employ per hour), then you may need to make decisions about which product gets the bulk of your resources. The product with the higher CMR should probably win out because it gets you a better return on the money you put into making it, and will help you cover your fixed costs at a lower sales volume.

To monitor operational efficiency

A declining CMR can signal rising variable costs or inefficiencies in production and delivery. Keeping a close eye on it can help you proactively identify and address these issues—and raise prices if needed— before they make a material impact on your bottom line.

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What is a “good” contribution margin ratio?

A “good" contribution margin ratio can vary widely across industries, so there is no one benchmark by which to measure. A highly scalable software-as-a-service (SaaS) company with low variable costs after development might aim for a significantly higher CMR than, say, an auto manufacturer with high raw-material and labor costs for every car produced. 

Generally speaking, you’ll want to achieve an industry-competitive CMR, but you may find that doing so comes with tradoffs. Cutting variable costs could mean sacrificing quality or customer satisfaction if you turn to cheaper materials or slower shipping times, for instance. And raising prices can improve your ratio but may come at the expense of sales volume if competitors are cheaper. 

4 ways to improve your contribution margin ratio

There are a number of ways you may be able to improve your CMR without alienating customers:

1. Look for ways to automate and streamline production

Explore whether automation or process improvements can reduce variable costs without compromising quality. You may also be able to reduce costs by consolidating vendors or re-negotiating contracts with suppliers. 

2. Prioritize products with the highest CMR

If you can identify products or services with higher CMRs, then you can allocate resources toward their growth. As they come to occupy a larger share of your revenue, your overall CMR should rise.

3. Leverage economies of scale

If you can increase your sales volume, you can spread fixed costs across a higher number of units. That should raise your CMR and improve overall profitability. Scale also gives you negotiating power with suppliers, and you may be able to secure lower prices.

Pricing

Are customers willing to pay more for your product or service? It’s worth finding out. If so, you can up your transaction prices to capture more value—so long as you can do so without losing customers. Other pricing strategies can help you increase sales revenue as well, such as tiered pricing models.

What’s the difference between contribution margin and gross margin?

Both contribution margin ratio and gross margin are measures of profitability, but in different ways. Gross margin is the percentage of revenue remaining after subtracting the direct costs of making goods and services. It measures how much revenue a company retains overall. The CMR, on the other hand, is the percentage of each sales dollar left after variable costs, and the degree to which each dollar contributes to fixed costs and profitability. Gross measures financial performance at a high level, while CMR is more useful for making product-level decisions about pricing and resource allocation.

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