Contribution Margin and Ratio: Definition, Formula and Example

Tally Solutions |Updated on: September 13, 2022

• Contribution margin and ratio
• Uses of Contribution Margin
• Formula of contribution margin and ratio
• How to calculate contribution margin?
• Example of contribution margin and ratio
• What is considered a good contribution margin?
• Can the contribution margin ratio be negative?
• TallyPrime for all your accounting needs

What is contribution margin and ratio?

The contribution margin tells a business how much revenue will remain after all the variable expenses have been accounted for. The contribution margin can be computed for a product line, the business, and a product unit. The contribution margin ratio is the revenue percentage which remains for profit, fixed costs, and fixed expenses. It is represented in a percentage format. Businesses that offer labor-intensive services are often the ones with a low contribution margin. A high contribution margin is oftentimes the case in businesses that are more capital-intensive in comparison. This is because they require massive facilities, machinery, and equipment.

Uses of Contribution Margin

Contribution margin and ratio are important for a variety of purposes such as the ones below.

Breakeven analysis

The contribution margin is used in calculating the break-even point. The formula to calculate the break-even point is total fixed expenses divided by the contribution margin ratio. If you wish to calculate the break-even point in units then you can do so too by dividing total fixed expenses by the average contribution margin per unit. The average contribution margin per unit is the value derived from all sales minus all variable expenses divided by the number of units sold.

Adjust product prices

By analyzing the contribution margin along with the break-even point, you can get valuable information about the efficiency of business operations. Businesses can decide about the pricing of products in this way. For example, if a product is generating high profits, then you can slightly increase or maintain the price of that product. If it is generating low or no profits, then you must reconsider its pricing accordingly or remove it from the product line if required.

Rethink product lines

The contribution margin gives you an idea of how well a product is doing. It segregates the good performing products with the bad ones in terms of profits. This means you can put your efforts into the product that is generating much higher profits and improve so that your other products are doing just as well. Or you have the option of discontinuing a particular product or product line if it is falling low on expectations.

Formula of contribution margin and ratio

The formula for contribution margin and ratio is as follows.

Contribution margin formula

Contribution Margin = Revenue – Variable costs

Contribution margin per unit formula

Contribution Margin Per Unit = (Revenue – Variable expenses) + Total Units

Contribution margin ratio formula

Contribution Margin Ratio = Revenue – Variable Costs / Revenue

How to calculate contribution margin?

The contribution margin calculation is simple as it consists of only three steps.

Step 1: Compute total revenue or net sales

The first step is to add up sales to get a net sales value of the product. The net sales value will deduct any allowances and sales return values. You can compute the net sales or revenue by using the formula gross sales – sales return – discount. Net sales are essentially the money that your business makes when it sells products.

Step 2: Add total variable costs

You need to compute the variable costs which are expenses incurred during the production of the product. The variable costs change depending upon the output. Some examples of variable costs include commissions, material costs, transportation costs, and labour costs. You must add all such costs to get a variable cost value.

Step 3: Compute the contribution margin

Once you have the two values, revenue and variable costs, you can compute the contribution margin by subtracting the variable costs from revenue. The contribution margin ratio can be computed by dividing the contribution margin by revenue.

What are fixed costs?

Fixed costs refer to expenses that are independent of volume. Fixed costs tend to be costs that are based on time rather than the quantity produced or sold by your business. Examples of fixed costs are rent and lease costs, salaries, utility bills, insurance, and loan repayments

Example of contribution margin and ratio

A manufacturer with a single product line sold 5000 units. The selling price of these products is Rs. 700 per unit. The fixed costs are Rs. 1,00,000. The SG&A expenses are Rs 150 per unit while the manufacturing expenses are Rs. 250 per unit. This means the variable costs are Rs. 400 per unit. According to this information, we can compute the contribution margin as follows.

Revenues = 5000 units x Rs. 700 per unit

Revenues = Rs. 35,00,000

Variable costs = 5000 units x Rs. 400 per unit

Variable costs = Rs. 20,00,000

The contribution margin formula is revenue minus variable costs. We will input the revenue and variable costs that we have just calculated to come to a contribution margin value.

Contribution margin = Rs. 35,00,000 – Rs. 20,00,000

Contribution margin = Rs. 15,00,000

Using the contribution margin ratio formula which is revenue – variable costs divided by revenue, we will compute it as follows.

Contribution margin ratio = Rs. 35,00,000 – Rs. 20,00,000 / Rs. 35,00,000

Contribution margin ratio = 0.4 or 40 percent

This means that for this business, for every Rs. 1 of revenue it generates, the contribution margin of the product is 40 paise or Rs. 0.40.

How important is contribution margin in business?

Contribution margin helps businesses analyze and compare products and determine which to keep and which to remove from their offerings, how to price a particular product, and more.

How to actively improve your business contribution margin?

Although there are many ways to improve contribution margin, here are some of the ways to improve contribution margin:

• Decreasing your cost of goods sold
• Lowering labor cost
• Optimizing cost for the maximum profit 

What is considered a good contribution margin?

In an ideal world, the contribution margin will be 100 percent but in the real world, this does not happen. You want to focus on keeping your contribution margin as high as possible because it shows that you have the funds available to take care of the overhead costs and fixed costs. It is difficult to define a particular number that is considered a good contribution margin because it depends on many factors. The contribution margin is relative because a good one depending on how the business has structured its expenses and its competitiveness.

How you can approach this is simple. You can calculate the contribution margin of each product. If you have different product lines then you can calculate the contribution margin for those product lines. Then you can analyse and determine how profitable each is. If you find that some products have a consistently low contribution margin, then perhaps it is time to discontinue those. This helps to streamline and focus on products that have a high contribution margin which positively affects the business.

Can the contribution margin ratio be negative?

A business can have a negative contribution margin ratio. When this happens, it indicates that the sales are lesser than the expenses and variable costs of the business. If your calculation revealed a negative contribution margin ratio, then you can eliminate it by increasing the selling prices of your products, taking out products which generate negative contribution margins, and lowering variable costs on a per-product basis. You can also market and promote products which have a high contribution margin.

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