Contribution Margin Ratio (CM
Ratio):
Contents:
-
Definition
-
Formula
-
Example
-
Importance
-
Review Problem
The contribution
margin as a percentage of total sales is referred to as
contribution margin ratio (CM Ratio).
The following
formula is used to calculate contribution margin ratio (CM
ratio):
CM Ratio =
Contribution Margin / Sales
CM ratio is
extensively used in
cost-volume profit (CVP) calculations.
Consider the
following contribution margin income statement of XYZ
private Ltd. in which sales revenues, variable expenses,
and contribution margin are expressed as percentage of sales.
|
Total |
Per Unit |
Percent of Sales |
Sales (400 units) |
$100,000 |
$250 |
100% |
Less variable expenses |
60,000 |
150 |
60% |
|
|
|
|
Contribution margin |
$40,000 |
$100 |
40% |
|
|
|
|
Less fixed expenses |
35,000 |
|
|
|
|
|
|
Net operating income |
$5,000 |
|
|
|
|
|
|
Calculate
contribution margin ratio
|
According to above
data of XYZ private Ltd. the computations are:
Contribution
Margin Ratio = (Contribution Margin / Sales) × 100
= ($40,000 /
$100,000) × 100
= 40%
In a company that
has only one product such as XYZ private Ltd CM ratio can also be
calculated as follows:
Contribution
Margin Ratio = (Unit contribution margin / Unit selling price) ×
100
= ($100 / $250)
× 100
= 40%
The CM ratio is
extremely useful since it shows how the contribution margin will
be affected by a change in total sales. To illustrate notice
that XYZ private Ltd has a CM ratio of 40%. This means that for each
dollar increase in sales, total contribution margin will
increase by 40 cents ($1 sales × CM ratio of 40%). Net operating
income will also increase by 40 cents, assuming that fixed cost
do not change.
The impact on
net operating income of any given dollar change in total sales
can be computed in seconds by simply applying the contribution
margin ratio to the dollar change. For example if the XYZ
private Ltd plans a $30,000 increase in sales during the coming month,
the contribution margin should increase by $12,000 ($30,000
increased sales × CM ratio of 40%). As we noted above, Net
operating income will also increase by $12,000 if fixed cost do
not change. This is verified by the following table:
|
Sales Volume |
Percent of Sales |
|
Percent |
Expected |
Increase |
Sales |
$100,000 |
$130,000 |
$30,000 |
10% |
Less
variable expenses |
60,000 |
78,000 |
18,000 |
60% |
|
|
|
|
|
Contribution margin |
40,000 |
52,000 |
12,000 |
40% |
Less
fixed expenses |
35,000 |
35,000 |
0 |
|
|
|
|
|
|
Net
operating income |
5,000 |
17,000* |
12,000 |
|
|
|
|
|
|
*Expected net operating income of
$17,000 can also be calculated directly by using the following
formula:
[P*=
(Sales × CM ratio) – Fixed Cost]
P*
= Profit
Problem 1:
Sales =
$5,000,000
CM = 0.40
Fixed cost = $1,600,000
Calculate
Profit.
Solution:
P = (Sales × CM
ratio) – Fixed Cost
P = ($5,000,000 × 0.4) – $1,600,000
P = $2,000,000 – $1,600,000
= $400,000
Problem 2:
A company has
budgeted sales of $200,000, a profit of $60,000 and fixed
expenses of $40,000. Calculate contribution margin ratio.
Solution:
P = (Sales × CM
ratio) – Fixed Cost
$60,000 = ($200,000 × CM ratio) – $40,000
$60,000 + $40,000 = ($200,000 × CM ratio)
CM ratio = $100,000 / $200,000
= 0.5
Some managers
prefer to work with the contribution margin ratio rather than
the unit contribution margin. The CM ratio is
particularly valuable in situations where trade-offs must be
made between more dollar sales of one product versus more dollar
sales of another. Generally speaking, when trying to increase
sales, products that yield the greatest amount of contribution
margin per dollar of sales should be emphasized.
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