Contribution Margin Ratio: Formula, Definition, and Examples

What is the Contribution Margin?

The contribution margin is the difference between the sale price of a product and the variable costs associated with making the product.

The formula for the contribution margin is:

Contribution Margin = Revenue - Variable Costs

• ‍Revenue: The money a company generates over a period of time (monthly, quarterly, or annually). Revenue is calculated as the price of a product or service multiplied by the quantity sold.
• ‍Variable costs: the costs that vary depending on the quantity sold. For example, if a company sells books online, the shipping costs for the books would be a variable cost that varies depending on the number of books sold. On the other hand, fixed costs remain the same regardless of the quantity sold. Common examples of fixed costs include salaries, rent, and utilities.

What is the Contribution Margin Ratio?

The contribution margin ratio represents a company’s revenue minus variable costs, divided by its revenue. In short, it is the proportion of revenue left over after paying for variable costs.

The formula for the contribution margin ratio is:

Contribution Margin Ratio = (Revenue - Variable Costs) / Revenue

If you already know the contribution margin, the contribution margin ratio formula can be simplified to:

Contribution Margin Ratio = Contribution Margin / Revenue

Contribution Margin Ratio Example

Suppose Company A has the following income statement with revenue of 100,000, variable costs of 35,000, and fixed costs of 20,000.

To calculate the contribution margin, we take the revenue and subtract the variable costs. In this case, it is 100,000 - 35,000 = 65,000.

To calculate the contribution margin ratio, we take the revenue, subtract the variable costs, and divide the result by the revenue. In this case, it is (100,000 - 35,000) / 100,000 = 0.65 or 65%.

We can also calculate the contribution margin ratio with a more simplified formula if we already have the contribution margin. For this, the formula would simply be contribution margin divided by revenue. In this example, it is 65,000 / 100,000 = 0.65 or 65%.

The fixed costs of 20,000 are not included in the calculation. However, they will play an important part in calculating the net income formula.  

What is the contribution margin ratio for?

The contribution margin ratio is used by finance professionals to analyze a company’s profitability. It is often used for building a break-even analysis, which helps companies determine at what point a new business project will reach enough sales to cover the costs. In other words, reach a profit of exactly zero.

Doing this break-even analysis helps FP&A (financial planning & analysis) teams determine the appropriate sale price for a product, the profitability of a product, and the budget allocation for each project.

What is a good contribution margin ratio?

The best possible contribution margin ratio is 100%. However, this implies that a company has zero variable costs, which is not realistic for most industries. As such, companies should aim to have the highest contribution margin ratio possible, as this gives them a higher likelihood of covering its fixed costs with the money remaining to reach profitability.

While a high contribution margin ratio is impressive, it is important to note that companies should not sacrifice the quality of their product or service purely for the sake of increasing the contribution margin ratio. Striking a balance is essential for keeping investors and customers happy for the long-term success of a business.

Fixed Costs vs. Variable Costs

Fixed costs stay the same regardless of the number of units sold, while variable costs change per unit sold.

Examples of fixed costs include:

• Office rent
• Salaries
• Business licenses
• Property tax

Examples of variable costs include:

• Direct labor
• Raw Materials
• Shipping
• Commissions per sale

Additional Resources

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