Contribution Margin Ratio (CM Ratio):
Learning Objectives:
- Define and explain contribution
margin ratio.
- Calculate CM ratio.
- What is the importance and benefit of
calculating CM ratio?
-
Definition of Contribution Margin Ratio
-
Formula
-
Calculation
-
Importance
-
Review Problems
The contribution margin as a
percentage of total sales is referred to as contribution margin ratio (CM
Ratio).
Formula or equation of CM ratio is as
follows:
[ CM Ratio = Contribution Margin
/ Sales ]
This ratio is extensively used
in cost-volume profit calculations.
Example:
Consider the following
contribution margin income statement of A. Q. Asem 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 A. Q. Asem 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 A. Q. Asem 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 A. Q. Asem 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 A. Q. Asem 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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