February 22, 2024

What Does Contribution Margin Ratio Tell You?

As with other important financial metrics, such as gross margin and operating margin, contribution margin ratio provides valuable insight into your company's profitability and helps guide business decisions. The article below explores what does contribution margin ratio tell you and how to use the metric to your advantage.

Contribution margin measures the amount of sales revenue left over after paying all the product's variable costs, such as raw materials and shipping, minus its fixed overhead costs (such as rent and utilities). This metric is different than gross margin, which includes all revenues including marketing expenses, because it only considers the actual sales that have actually been generated.

A product with a positive contribution margin indicates that the profit earned from selling each unit of a good or service exceeds the variable cost associated with producing and selling it. This metric is particularly useful for evaluating the profitability of new products and services, as it allows you to see how much potential profit can be made from each sale before you have to commit to a large production run.

Companies can increase their contribution margin ratio by either reducing their fixed costs or increasing sales. Often, it is easier to decrease variable costs than it is to increase fixed costs. For example, if your company uses a scheduling and labor management solution that can help control your labor costs, this will reduce your company's overall variable cost. Similarly, if your business has high advertising or other promotional costs, these are also variables that can be easily reduced with careful analysis and budgeting.

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