What Are Things That Could Increase or Decrease the Contribution Margin Ratio?
Manufacturers and other businesses that deal in goods constantly monitor the relationship between the cost of acquiring and producing goods and the prices at which they’re sold. One of the many financial tools that managers use to monitor this difference is the contribution margin ratio. However, to make effective use of the contribution margin ratio, it is vital to understand how and why it increases and decreases.
The contribution margin, an essential component of the contribution margin ratio, is equal to the total revenue minus the variable costs for generating that revenue. Contribution margins are commonly calculated on revenues generated by specific products rather than on a company-wide basis. By isolating a product’s variable costs, which are expenses that only exist because of the product being analyzed, companies are better able to assess the product lines worth manufacturing and the product lines that should be discontinued. Fixed costs, however, do not affect the contribution margin since these expenses must be paid regardless of whether the product is produced or not. Fixed costs also never change in amount. For example, if you operate a bakery, the monthly rent you pay for retail space is considered a fixed cost, whereas the cost of flour is variable since your flour expenses will be higher the more items you sell.
Contribution margin ratios are calculated as the contribution margin divided by sales revenue, then multiplied by 100 so it can be expressed as a percentage. To illustrate, suppose your bakery sells 100 blueberry pies per month at $10 each, which generates $1,000 in revenue. If your variable expenses for the pie, such as the cost of blueberries, sugar and other ingredients total $300, the contribution margin is equal to $700 and the ratio is equal to 70 percent. This 70 percent contribution margin ratio indicates that the contribution margin will increase by 70 cents for each additional dollar of blueberry pie revenue. Assuming that the cost of ingredients per pie remains the same regardless of the quantity, your bakery’s net income will increase by 70 cents for each dollar of revenue as well.
An increase in the contribution margin ratio is always more desirable than a decrease. Some of the things that will increase the ratio include a decrease in a product’s variable costs, such as when the market price of blueberries falls, for example. You can also increase the contribution margin ratio by raising the price of the products you sell.
When the contribution margin ratio decreases, your bottom line will be adversely affected since it indicates you’re earning less profit on each product sold. An increase in a product’s variable expenses can be a reason for the ratio to decrease. Moreover, having to decrease the price you charge for a product, such as when the competition is becoming fiercer will decrease the ratio as well.