Pheonix was a professional classical guitar player until a motorcycle accident left him disabled. After long months of therapy, he hired an experienced luthier and started a small shop to make and sell Spanish guitars. The guitars sell for $700, and the fixed monthly operating costs are as follows: $$\begin{array} { | l | r | }
\hline \text { Rent and utilities } & \$ 810 \
\hline \text { Wages and benefits toluthier } & 2500 \
\hline \text { Other expenses } & 480 \
\hline
\end{array}$$ Pheonix's accountant told him about contribution margin ratios, and Pheonix understood clearly that for every dollar of sales, $0.60 went to cover his fixed costs, and anything above that point was profit.
Pheonix is planning to increase the sales price to $750. What impact will the increase in sales price have on the contribution margin ratio?

Question

Pheonix was a professional classical guitar player until a motorcycle accident left him disabled. After long months of therapy, he hired an experienced luthier and started a small shop to make and sell Spanish guitars. The guitars sell for $700, and the fixed monthly operating costs are as follows: $$\begin{array} { | l | r | } 
\hline \text { Rent and utilities } & \$ 810 \
\hline \text { Wages and benefits toluthier } & 2500 \
\hline \text { Other expenses } & 480 \
\hline
\end{array}$$ Pheonix's accountant told him about contribution margin ratios, and Pheonix understood clearly that for every dollar of sales, $0.60 went to cover his fixed costs, and anything above that point was profit.
Pheonix is planning to increase the sales price to $750. What impact will the increase in sales price have on the contribution margin ratio?

Quizplus · Accepted Answer

To calculate the contribution margin ratio, we need to subtract variable costs (costs that vary with the level of sales) from sales revenue and divide the result by sales revenue. In this case, there are no variable costs, so the contribution margin ratio is simply the ratio of fixed costs to sales:

Contribution margin ratio = Fixed costs / Sales revenue

Given that $0.6 of every dollar goes to cover fixed costs, we can write this as:

Contribution margin ratio = 1 - 0.6 = 0.4 = 40%

If Pheonix increases the sales price to $750, his new contribution margin ratio will be:

Contribution margin ratio = Fixed costs / Sales revenue
= 11ea8553_2bcb_39cb_a343_6db8988e6e77_TB5019_00 / $750
= 0.5867

Or approximately 58.67%. This is an increase from the previous ratio of 40%.

Pheonix Was a Professional Classical Guitar Player Until a Motorcycle