Before we start, it may help to review the definition of the contribution margin ratio. If you manufacture an item, for example a widget, you need to know how much it costs to make. You have variable costs, such as the materials that go directly into the widget, and you have fixed costs, such as rent and insurance. For the most part, your fixed costs don't change whether you make 100 widgets or 1,000 widgets.
But the variable costs do change. If you need $5.00 worth of materials for 1 widget, then you need $50.00 worth of material for 10 widgets. But your rent doesn't change. If you sell your item for $10.00, that difference between the $5.00 worth of material and the $10.00 sales price has to cover all the remaining costs and provide you the profit. That difference is your Contribution Margin Ratio.
The contribution margin ratio is often identified as a percentage. For example, in the preceding example, the contribution margin ratio would be 50%.
Knowing your contribution margin ratio is very important. It helps you determine whether to keep manufacturing an item, or whether to raise its price.
If you are a retail store, the Contribution Margin Ratio may also be called the Gross Margin Ratio/Percent. The variable costs in this instance would be the cost of the product. Again, the overhead costs, like rent etc., would be part of the difference.
The fastest way to determine your Contribution Margin Ratio is to subtract your total variable costs from your total sales revenue. What's left is your Contribution Margin Ratio.
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