It is Thursday morning and your boss just called you into her office. “Why is our net profit down 10% this quarter? It looks like our cost of goods sold has gone up dramatically! Can you check into this and get back to me before the end of the day?” You need to put on your thinking cap and figure out why net profit has dipped. She mentioned that our cost of goods sold was higher. Could there have been a price increase on one of the components of our product? Off to visit purchasing to do some research!

The contribution margin ratio is the difference between a company’s sales and variable costs, expressed as a percentage.  This ratio shows the amount of money available to cover fixed costs. It is good to have a high contribution margin ratio, as the higher the ratio, the more money per product sold is available to cover all the other expenses.

Contribution margin ratio formula:

[latex]\displaystyle\frac{\text{sales}-\text{variable expenses}}{\text{sales}}[/latex]

If we go back to our Monte Corporation example, we can calculate their contribution margin ratio as follows:

[latex]\text{sales}=\$2000[/latex], and [latex]\text{variable expenses}=\$800[/latex], so

[latex]\displaystyle\frac{\$2000-\$800}{\$2000}=60\%[/latex]

For every additional widget sold, 60% of the selling price is available for use to pay fixed costs.

What would happen if a supplier raised their price by $1 per unit on a part for the widget? This would increase the variable costs by $1 per unit, bringing the variable cost per unit to $5. How would this affect the contribution margin ratio for Monte Corporation?

[latex]\text{sales}=\$2000[/latex], and [latex]\text{variable expenses}=\$1000[/latex], so

[latex]\displaystyle\frac{\$2000-\$1000}{\$2000}=50\%[/latex]

The addition of $1 per item of variable cost lowered the contribution margin ratio by a whopping 10%. You can see how much costs can affect profits for a company, and why it is important to keep costs low.

As a manager, you may be asked to negotiate or talk with vendors and perhaps even to ask for discounts. Small differences in prices of your supplies can make a huge difference in the profitability of a company.