Contribution margin ratio: why it's important for businesses

Contribution margin ratio is the percentage of a sale that's left over once you cover the variable costs associated with the product(s) sold. This number can help with profitability analysis, calculating your break-even points, and fixed cost management.

Table of contents

• What is the contribution margin ratio?
• Contribution margin ratio formula
• Fixed costs vs variable costs
• Contribution ratio vs gross profit
• Example of contribution margin ratio
• FAQs on the contribution margin ratio

Key takeaways

• Contribution margin ratio measures the percentage of each sale that contributes to covering fixed costs, helping businesses assess their profitability and break-even point.
• The formula for contribution margin ratio is simple: subtract your variable costs from revenue and divide by revenue. It’s a useful way to evaluate the profitability of individual products.
• Accurately distinguishing between fixed and variable costs is crucial for calculating your contribution margin ratio and improving your profitability analysis.
• Contribution margin ratio helps guide strategic decisions, including pricing, cost management, and sales strategies.
• This ratio is useful for assessing product performance, as it helps identify which products or services contribute most to covering fixed costs and driving profits.

What is the contribution margin ratio?

A contribution margin ratio measures the proportional relationship between revenue and variable costs. This profitability ratio shows you the proportion of each sale that goes toward variable costs. It also helps with your break-even analysis – that is, the dollar amount of sales you need to cover your fixed costs.

The ratio helps guide pricing decisions and cost structures – as outlined in this resource from Mass.gov – and is a useful way to assess how much revenue different products or services contribute to your bottom line.

Contribution margin vs gross profit

Understanding the difference between gross profit and contribution margin is important when calculating the contribution margin ratio, which helps businesses assess the profitability of individual products and make strategic decisions.

• Gross profit is the difference between revenue and the cost of goods sold (COGS), giving you a broad picture of how much profit you’re making after covering the direct costs of production.
• Contribution is the difference between revenue and variable costs (which include COGS as well as costs like marketing or sales commissions). It reveals how much of your revenue is left to cover fixed costs and contribute to profits.

Contribution margin focuses on the costs and profitability of units for sale, and businesses can use this ratio to do break-even analysis or product-level profitability assessments. Gross profit measures the overall financial health of the business, and the gross profit margin can help you make decisions about overall efficiency.

You can get a little more creative with the contribution margin by looking closely at your income statement . Identify other variable costs that may not be immediately obvious. For example, marketing expenses tied directly to a product, or sales commissions. According to Harvard Business Publishing, one of the trickiest parts of calculating this ratio is accurately distinguishing between fixed and variable costs. The more precise you are in this step, the clearer your contribution margin and overall profitability will be.

Fixed costs vs variable costs

To understand the contribution margin ratio, it's crucial to first grasp the difference between fixed and variable costs, as these directly impact your profitability calculations.

• Variable costs are costs that change in direct relation to the production or sale of a product. These could include things like raw materials, labor for production, or inventory costs. In essence, the more you produce or sell, the higher your variable costs will be.
• Fixed costs, on the other hand, remain the same regardless of how much you sell. These are costs like rent, utilities, or salaries for employees who aren’t directly involved in production. Fixed costs are incurred whether you make a sale or not.

By identifying and understanding both types of costs, you can more accurately calculate your contribution margin ratio. The ratio reveals how much of your revenue is available to cover fixed costs after accounting for the variable costs. This insight helps guide pricing decisions, profitability assessments, and strategies for managing costs effectively as your business grows.

Of course, you're never guaranteed a sale. It’s a good idea to do a variable cost calculation when bringing in new products, for which you first need to examine and calculate your marginal costs.

Calculating your contribution margin ratio

The contribution margin ratio formula is simple: subtract your variable costs from your revenue, then divide that by your revenue:

Contribution margin ratio = Revenue – variable costs / revenue

For instance, if revenue is $10 and variable costs are $5, your contribution margin ratio is 50%. So, half of every sale can go toward fixed costs.

Example calculation the contribution margin ratio

Here’s a practical example.

Say revenue is $500,000 and variable costs are $400,000.

500,000 – 400,000 / 500,000 = 20%

That means 20% of your revenue can contribute to your fixed costs – if you increase revenue by $100,000, you have an extra $20,000 for fixed costs.

This ratio is useful for you if your business is expanding. They help you pay attention to the profit potential and identify when you need to increase fixed costs to support a higher volume of sales.

The contribution margin ratio can also guide decisions about product pricing and sales commission. For instance, if you're trying to increase profits, the main options are to increase prices, lower costs, or shift focus to different types of sales. The contribution ratio can help you decide what to do.

FAQs on the contribution margin ratio

Here are some common questions about the contribution margin ratio and how it works.

What’s the difference between a contribution margin and the contribution margin ratio?

A contribution margin is the difference between revenue and variable costs.

Say you run a bakery. You spend $4 on supplies and $16 in labor to bake a cake – these are your variable costs. You then sell the cake for $30 – that's your revenue. The difference is $10 – that's your contribution margin.

The contribution margin ratio is the proportion of revenue left over after covering variable costs. In this case, you have $10 left after variable costs and your revenue was $30. That's a 33% contribution ratio.

Run this formula on your different products or services to judge how profitable they are.

How do I improve my contribution margin? (H3)

It’s simple in theory: just increase revenue or decrease variable costs, or both. But in practice it takes work:

• Watch market trends and consumer sentiment to figure out when you can raise prices
• Keep an eye on where you can cut costs without sacrificing quality – perhaps you can negotiate better deals with vendors and invest in tech that helps streamline your processes

Can I use the contribution margin ratio to make hiring or expansion decisions?

Yes, you can. The ratio helps predict how much extra money you'll have if you increase sales, which can help you calculate how much money you'll have left to hire employees or expand operations as you increase sales.

Of course, you’ll have to consider things like whether your customer base will support more sales. Here’s more info on ways to expand your business.

What is a good contribution margin ratio for my business?

Of course, you want to shoot for 100%, but eliminating all costs isn't really possible. The target number varies based on your industry – a company selling software subscriptions, for instance, probably has a higher contribution margin ratio than a business selling products that cost a lot to produce or purchase.

Think about working with a mentor or financial advisor and researching industry publications to learn about the benchmark contribution margins for your industry, and your products or services.

How do I calculate the contribution margin ratio for multiple products?

Break down the revenue for each product or category of products. Then identify the fixed costs related to those products, and calculate the ratio. This makes it easy to identify your most profitable products.

Use Contribution Margin Insights to Boost Profits

Tracking your contribution margin ratio helps you make smarter business decisions and increase profitability. With Xero, you can easily monitor the key numbers that drive your success—helping you control costs, set better prices, and grow your bottom line.