Definition: Contribution margin ratio is a financial ratio that measures the percentage of sales dollars that exceed variable costs and can be used to cover fixed costs. In other words, it’s a profitability ratio that shows the percentage of sales revenue that will either go to fixed costs or profit.
What Does Contribution Margin Ratio Mean?
The contribution margin ratio formula is calculated by dividing the sales less variable costs by the sales. The equation can be simplified by dividing the margin by the sales revenue.
Let’s take a look at an example. Sam’s Food Truck operates in the greater DC area and sells pizza to the public. Sam has several variable costs including food supplies like dough, toppings, and sauce. He also has several fixed costs like employee labor and truck license fees. Sam is currently trying to figure out what price he should sell his pizza for in order to generate an adequate profit.
Sam estimates that he spends $3 on variable costs per pizza and has fixed costs of $250 a day. On average, Sam sells 100 $10 pizzas each day making his contribution margin ratio 70 percent ($10 – $3 / $10). Sam’s total sales revenue each day is approximately $1,000 on average. This means that $700 of the total sales will be able to cover his $250 of fixed costs leaving him with $450 of profit each day.
Depending on Sam’s market and customer loyalty, increasing his prices could force some of his customers to leave. On the other hand, the increased margin could be enough to recover from the loss of customers.
As you can see, the contribution margin ratio is a calculation that management can use in a number of different ways. It can be used to establish prices, like in the Sam example, or run profit estimates and analyzes for various production and output levels. Management can also use the CM ratio to find inefficient processes that need improvement.