The contribution margin ratio (CM ratio) of a business is equal to its revenue less all variable costs, divided by its revenue. It represents the marginal benefit of producing one more unit. Here is the formula for contribution margin ratio (CM ratio):
The fixed costs of $10 million are not included in the formula, however, it is important to make sure the CM dollars are greater than the fixed costs, otherwise, the company is not profitable.
The contribution margin is not necessarily a good indication of economic benefit. Companies may have significant fixed costs that need to be factored in.
It can be important to perform a breakeven analysis to determine how many units need to be sold, and at what price, in order for a company to break even. To learn more, check out our Financial Analysis course.
In order to perform this analysis, calculate the contribution margin per unit, then divide the fixed costs by this number and you will know how many units you have to sell to break even.
Building on the above example, suppose that the company sold 1 million units. That means the CM per unit is $20. Fixed costs are $10 million so the company has to sell 500,000 units to break even ($10 million / $20 per unit = 500,000).
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