Contribution margin

Contribution margin - is the ratio of operating leverage. This ratio is the percentage of a firm's marginal profit per unit sale and it’s calculated by dividing contribution margin by firm’s sales. This ratio is very useful when calculating which part of sales is contributed to profit and fixed costs and has plenty of examples to show how this ratio works in reality.

First of all, we should understand what the contents of the contribution margin formula are. The denominator of the formula is the total revenue of the company, taken from the profit and loss statement. For the numerator stands contribution margin, that is calculated by decreasing sales with variable costs.  If you multiply it by 100%, the result of this formula shows what percentage of the sales is dedicated to cover fixed costs and to earn profit. The higher ratio shows that the company has more abilities to sell a product with lower variable costs.

If the sales of the company are not so high, comparing to variable costs, it means, that the contribution margin is too low and it might be that the company is not earning any profit, if fixed costs are high. It is possible that the company collected 50 thousand of sales in Euros, but spent 35 thousand Euros for variable costs to sell it, so the contribution margin ratio will be 30%. The same company spends 25 thousand Euros to finance fixed costs, so it means that the company has negative operating income.

Let’s say that the sales of other company are 150 thousand of Euros, but the company had 50 thousand Euros of variable costs to make these sells for this period. The contribution margin for the company is 100 thousand Euros. It means, that only fixed costs left to deduct if we want to know the profit. If we calculate contribution margin ratio, it will be 66,67%, so it means that One Euro of sales earns almost 67 cents of the contribution margin and by the same amount of money it increases operating income.

The companies that have products with high contribution margin ratios should develop these products and emphasize the production of them. But if the companies produce products that have low contribution margins, they should stop making them, because it is not profitable. There might be that the company is making some products that are not profitable, but these products are used for promotions, as a gift to represent company, or used as a business gift, so the company can finance the production of this product from other profitable products. Usually, if the company is making such gifts, the amounts of it is much more less than other products in the company, and the company is not using all of these products for sale. Just imagine that the University has a press and it is printing information books about University. Some of them are used for representing purposes, and the other part is for sale at University book shop. Contribution margin of making these books about University will not be so high like for printing course books. The contribution margin for it will be low, because variable cost of making these books are high and it is calculated for the whole amount of printed books, but the revenue is taking only from the sold ones.

When the investor is looking at the contribution margin before investing, he should check what fixed costs are following that ratio, and he should find out what are the amount of sales and products made. If he finds out that the company has problems with minimizing variable costs assuring secure profit or it’s unable to sell its product at competitive price, it is possible that the company is not able to produce products with enough quality at these variable and fixed costs, and he should be aware of that company, because something is wrong with that business and its management.

Other ratio groups:
EBITDA
Value ratios
Efficiency ratios
Profitability ratios
Liquidity ratios
Leverage ratios
Other financial ratios
EBITDA

Efficiency ratios