 Hello and welcome to the session in which we would look at the contribution margin ratio. When we say ratio it means a percentage. In the prior session we looked at the contribution margin, how do we compute the contribution margin. In this session we're going to be looking more at the contribution margin ratio and how do we use this ratio to make business decisions. So what is the contribution margin? Well it's the selling price minus the variable cost. Basically put if we have a product and we're selling a product for ten dollars it's costing us six dollars to buy the product. Six ten minus six will give us a contribution margin of four dollars per one unit. Now we can take this information and compute a percentage to figure out how much each unit we are selling is contributing to our margin, to our contribution margin. Well to compute the contribution margin ratio which is a percentage will take the contribution margin which is four dollars as computed above divided by the sales. Sales is ten dollars we're only considering one unit and this gives us the contribution margin ratio of forty percent. So what did we do? Why did we do this? Well because for some companies they might have sales of for example one hundred dollar sales and the contribution margin is forty dollars and for some companies they might have sales of one billion dollar. Then how can we compare a company with the sales of a hundred dollar, you know don't read it literally, all I'm trying to say is there's a difference in size and a company with sales of a billion. Well we can take the company with sales and billions of dollars figure out their contribution margin and let's assume their contribution margin is actually three hundred million. If their contribution margin is three hundred million and their sales is one billion we would say that this company has a contribution margin of thirty percent. So notice although the size of the companies although I'm being extreme here but extreme to make the point this is company A, this is company B. If I'm comparing company A to company B once I compute their contribution margin ratio one is forty percent one is thirty percent then I can compare them then they are both we are basically factoring the size out and using percentages. So this is another way how we use the contribution margin ratio to make decisions and this is this is used in when you conduct an audit when you conduct financial statement analysis you would use those contribution margin ratio. So this is the company that we are working with Adam electronics retailer remember Adam sells tablets and the price per tablet the price per tablet is five hundred dollars and for this scenario we are selling four hundred tablets four hundred tablets times fifty dollars is sales of two hundred thousand if you're not copy this information down because we're going to be using the data from this example throughout this session variable cost per one tablet is three hundred dollars so we're selling tablets so the variable cost is three hundred times four hundred is one thousand one hundred and twenty thousand our contribution margin which is sales notice sales less variable cost is eighty thousand then we deduct the fixed cost and we happen to have a net operating profit of zero but we can also compute the contribution margin for this company well how do we compute the contribution margin we can take two hundred divided by five hundred and this is the contribution margin per unit the contribution margin ratio same thing we can take the total contribution margin divided by total sales and it's also going to give us forty percent so the contribution margin whether you use the price per unit or the total contribution margin divided by total sales it's going to give us the same percentage now also we could compute what's called the variable expense ratio. And the variable expense ratio is taken variable expenses per unit divided by sales per unit or total variable expenses divided by total sales. Sometime you might be giving the individual price, sometime you might be giving the total, you can go back and forth and we'll see in an example later how we can go back and forth between those two ratios. Now what does that mean? What does it mean that we have a 40% contribution margin ratio? It means each dollar in sales, each dollar in sales that we can generate, each increase result in total contribution margin of 40 cents. So every time we sell for $1 we can add to our contribution margin 40 cents. Now if we sell $100 we can add $40 so on and so forth. Now how can we use the now this information to make a prediction to do what if analysis? Well before we proceed most likely you are looking for some help. You are looking to learn about the contribution margin. You are either a student or a CPA candidate or a CMA candidate either or check out my website farhatlectures.com. I can help you with your accounting courses, your CPA preparation, CMA preparation. I have lectures multiple choice true false that's going to help you learn the material. This is a partial list of all my accounting courses. My CPA resources are aligned with your backer, Roger, Gleam, Wiley so it's very easy to go back and forth between my material and your CPA review course. I also give you access to pre to previously released AI CPA questions with detailed solution. If you have not connected with me on LinkedIn please do so. Take a look at my LinkedIn recommendation like this recording. If you're watching it means it's helping you like please like it. Share it with other connect with me on Instagram, Facebook, Twitter, Reddit and I do have a group me account for Facebook on group me for CPA candidate. So how can we use the contribution margin ratio? Well we can use it to predict what would our profit be if things changes. What if tablet sales increase from 400 to 500? Remember in the original example we sold 400 tablets so it's an increase of $100. Well we sell each tablet for $500 so that's an increase in sales of $50,000. Now knowing what we know we have a contribution margin ratio of 40%. Well guess what? If we increase sales by 50,000 it means we should increase our contribution margin by 20,000 and this should flow to the bottom line because in the example that we worked remember in the example that we worked we already covered the fixed expense. So let's prove this. Let's show you this in a contribution margin format. Well total sales now is 250,000 because we increased tablets by 100 tablets again 100 times 50 will give us give us an additional $50,000 in sales. From the sales we deduct the contribution margin which is 500 tablets times $300 that's the variable cost. Sales minus variable expenses or variable costs will give us a contribution margin of 100 minus 80 will give us a profit of 20,000 which is an increase in profit from zero to 20,000 and it's basically what we predicted even before we went through this computation. We could also use the contribution margin ratio using what's called an equation and basically what is an equation and this is what you need to be very familiar with the contribution margin ratio income statement because the equation is derived from that. What is the contribution margin income statement? Let's take a look at it one more time. It's sales minus variable cost equal the contribution margin minus fixed cost equal to your net profit or net operating income. So we can express profit too if we can take profit. Profit should equal to you could use the contribution margin ratio for our purposes is 40% multiplied by sales that's going to be our contribution margin then we can deduct the fixed expenses. So it's basically in a sense it's a shortcut but it's derived from the contribution margin income statement. So we are not doing anything that you should not be familiar with except we are expressing this information differently or another way to compute profit is to take the unit contribution margin which is $200 per unit this is this is dollar amount unit contribution margin versus the unit the unit ratio the contribution margin ratio multiply by quantity. Quantity is how many units we are going to sell then we can deduct the fixed cost. Now let's take a look at an example. What do we expect the profit to be if sales is 600 tablets the selling price is 500 and 300 variable cost basically the same data well let's use the contribution margin ratio of 40 percent remember for this example three 200 divided by 500 is 40 percent our contribution margin is 40 percent. So here what we do we'll take 40 percent times sales that's going to give us 120,000 minus fixed cost will give us 40,000 of profit or we can use the contribution margin per unit which is $200 times the quantity we're selling 600 that's going to give us 120,000 minus fixed cost of 80,000 will give us a profit of 40,000. So make sure you are familiar with this formula because you will need to use it you will need to use it. So let's take a look at this exercise which can be found at farhatlectures.com and this is what you need to do after you learn the concept you really want to go to Farhat Lectures and practice exercises like this one practice multiple choice zinc talk company manufacturers and sells a single product has provided the following data concerning its most recent month of operation sales 6,300 unit at total sales of 415 800 variable cost of 289 800 contribution margin is 126,000 fixed cost 98,500 and the net operating income based on the scenario is 27,500 simply put what they're given us here and if you're giving this on the exam that's a great this is the contribution margin formula or ratio or income statement which will be very very easy for you once you know how this is all structured so sales minus variable cost equal to the contribution margin minus fixed cost equal to net operating income they're asking you what happened if sales is 6,100 unit what will be the net contribution margin actually immediately you should be able to eliminate two choices it cannot be 27,500 it cannot be 122 because it has to be less than 27,500 it's either B or D so if you're guessing you just have to guess and you're better off with 50% chance well you don't have to guess we're gonna go ahead and work this problem well for one thing I can find the contribution margin ratio immediately by taking 126 126,000 divided by 415 800 and it's gonna be 0.30 3030 rounding okay it's not it's not a good ratio to illustrate but all I did is I take 126 contribution margin divided by sales this is the contribution margin ratio I don't know my selling price per unit but can I find my selling price per unit sure I can if my total sales is 418 415 800 for 6,300 unit I can take the total sales divided by the number of units I sold and by doing so I will find my selling price per one unit which happens to be divide this by 6,300 is $66 also I can do the same thing for my variable cost per unit because it varies in proportion to sales so my variable cost total is 289 800 divided by 6,300 unit and this is gonna give me my contribution margin for one unit and that's $46 now if I take sales minus variable cost easy $20 if I take $20 divided by 66 it's gonna give you back to this ratio 0.3 0.30 3030 forever which is not gonna be good one if we do the contribution margin it's gonna round but we don't have to use the contribution margin would use the contribution margin per unit now the question is back to the question what's my operating operating income well if I'm selling 6,100 unit and my contribution margin per unit is $20 if I take 6,100 times $20 that's gonna give me that's gonna give me $6,100 times $20 that's gonna give me a total contribution margin of 122 I multiplied by the contribution margin because I know that it's $20 right here now from the contribution margin all what I have to do deduct my fixed expense and that's gonna be 98,500 that's gonna give me 23,500 now if I use the other formula which is the percentage first I have to find sales it's 6,100 times sales is selling price per unit 66 so if I take 6,100 unit 6,100 times $66 that's gonna give me total sales of 402 600 now you have to multiply by .303030 repeating because this is gonna be a rounding issue I did this and it's gonna be if I do it you know for several one it's gonna be it's gonna give me if I do it .30303030 okay it's gonna give me contribution margin again of 122 so I'm using the percentage again if I deduct 98,500 it's gonna give me 23,500 the same answer so this problem can be found with detail this problem and other problems for that matter can be found on can be found on farhatlectures.com and this is where my farhatlectures.com can help you learn in addition to your the lectures so take advantage of the subscribe invest in yourself the CPA exam is worth it your accounting education is worth it stay safe and good luck