- Explain why changes to key cost-volume-profit factors can significantly affect planning and decision making
You just got a message from purchasing that the main component in your dry erase markers has gone up by 50 percent! You get out your calculator and start working on how this will affect your contribution margin this quarter. How are you going to explain this one to your supervisor? What are your options to keep your contribution margin high enough to cover the rest of your company’s expenses without a massive price increase in the product? Let’s get to work figuring out what to do.
So we talked about the key components of how many products we sell, what costs are involved in making those products and how they interrelate to create a profit or a loss. As a manager, you may be responsible for making sure that costs are kept under control, or sales numbers are kept at a certain level to keep your company profitable.
Even a slight change in costs can have a significant effect on the profitability of a company. Looking back at the contribution margin from the Monte Corporation example, let’s look at how small cost changes might affect the overall profitability of the company. An increase from a supplier of $1 per widget seems insignificant when you look at one widget, but what happens as sales volume goes up and down? What if your rent goes up or you are hit with a sales slump?
Maybe you choose to take production overseas, or purchase a machine to replace employees. CVP analysis helps you to make these decisions.
Monte Corporation has the following information available to you:
- Selling price of the widget- $10
- Current variable expense per widget $4.00
- Fixed costs $400 per month
They are notified by a vendor that the cost for the main component is going from $1.00 each to $2.00 each, which will bring their variable expense per widget to $5. How will this affect their contribution margin?
$10.00 − $4.00= $6.00 is now going to be $10.00 − $5.00= $5.00
Remember the contribution margin is how many dollars are available from the sale of each widget to cover fixed expenses.
The contribution margin ratio was 60% and is now going to be 50%. This is a huge difference for a $1.00 increase in component price. As we work through this module, keep in mind ways to possibly decrease costs, increase price, or other ways to save money on manufacturing. As a manager, you will have many decisions to make, sometimes they may be tough ones.