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and profit. CVP focuses on how profits are affected by the following five elements:
1. Prices of products.
2. Volume or level of activity.
3. Per unit variable costs.
4. Total fixed costs.
5. Mix of products sold.
Contribution income statement emphasizes the behavior of costs and is prepared for management use and is not
ordinarily available to those outside the company.
Contribution Margin
- If each unit sold provides $100 in CM then, The number of units needed to break even = Fixed -
Expenses/ CM per unit
- Once the break-even point is reached, operating income will increase by the unit CM for each
additional unit sold
- To summarize, if sales are zero, the companys operating loss equals its fixed expenses. Each unit that is
sold reduces the loss by the amount of the unit CM. Once the break-even point has been reached, each
additional unit sold increases the companys operating profit by the amount of the unit CM.
Rearrange the above equation to isolate Q and let profit = 0, to determine the break even number of units.
The CM expressed as a
percentage of total sales is
referred to as the contribution
margin (CM) ratio. This ratio is
computed as follows:
This leads to a useful equation that relates the CM ratio to the variable expense ratio as follows:
Incremental Analysis; An analytical approach that focuses only on those items of revenue, cost, and volume
that will change as a result of a decision.
Suppose the sales manager thinks that a $10,000 increase in the monthly advertising budget (FC) would
increase monthly sales by $30,000. Should the advertising budget be increased?
$700 decrease in
operating income can be
verified by creating a
contribution income
statement as the one in
the left.
- No fixed expenses are included in the computation. This is because fixed expenses are not affected by
the bulk sale, so all of the additional revenue that is in excess of variable costs goes to increasing the
profits of the company.
Equation Method:
The break-even point in total sales dollars, X, can also be directly computed as follows:
X = 0.60X + $35,000 + $0
X = $87,500
Note: In Break Even Analysis, the numbers should always be rounded up for sales level and units.
The Formula Method: The approach centers on the idea discussed earlier that each unit sold provides a certain
amount of CM that goes toward covering fixed costs.
A variation of this method uses the CM ratio instead of the unit CM. The result is the break-even in total sales
dollars rather than in total units sold:
Thus, the target operating profit can be achieved by selling 750 speakers per month, which represents $187,500
in total sales ($250 750 speakers).
The Formula Method: The second approach involves expanding the formula used to determine break-even
units to include the target operating profit as follows:
The dollar sales needed to attain the target operating profit can be computed as follows:
Cost Structure: The relative proportion of fixed and variable costs in an organization.
If sales are expected to be greater than $100,000 then sterling farms (low VC) is better because it has a
higher CM and its operating income will therefore increase more rapidly as sales increase.
Bogside Farm is less vulnerable to downturns than Sterling Farm for two reasons.
- First, due to its lower fixed expenses, Bogside Farm has a lower break-even point and a higher margin of
safety, as shown by the computations above. Therefore, it will not incur losses as quickly as Sterling
Farm in periods of sharply declining sales.
- Second, due to its lower CM ratio, Bogside Farm will not lose CM as rapidly as Sterling Farm when
sales fall off. Thus, Bogside Farms income will be less volatile.
Operating Leverage: a measure of how sensitive operating income is to percentage changes in sales. Operating
leverage acts as a multiplier.
- If operating leverage is high, a small percentage increase in sales can produce a much larger percentage
increase in operating income.
The degree of operating leverage is a measure, at a given level of sales, of how a percentage change in sales
volume will affect profits. It is computed by the following formula:
Bogside = 4
Sterling = 7
In general, this relation between the percentage change in operating income is given by the following formula:
Percentage change in operating income = Degree of operating leverage Percentage change in sales
- If two companies have the same total revenue and same total expense but different cost structures, then
the company with the higher proportion of fixed costs in its cost structure will have higher operating
leverage.
- The degree of operating leverage is greatest at sales levels near the break-even point and decreases as
sales and profits rise.
o Because as you get closer to the break even point, net income which is the denominator of the
degree of operating leverage formula, approaches 0.
Indifference Analysis: At which point will a company be indifferent between using a Labour intensive
program (high VC and low fixed) and a Capital intensive production system (high FC and low VC) assuming
the quality is the same.
We can calculate the point at which Goodwin will be indifferent about using a LIP system versus a CIP system
as follows:
1. Determine the unit CM multiplied by the number of units (Q) minus the total fixed costs of each
alternative.
2. Set up an equation with each alternative on opposite sides of the equal sign.
3. Solve for Q, the indifference point:
$12Q $1,800,000 = $18Q $3,600,000
$6Q = $1,800,000
Q = 300,000 units
Shortcut:
Calculating the break-even point in units when a company sells more than one product. The approach is based
on calculating a weighted-average CM per unit for the multiple products based on the existing unit sales mix
and the individual CM per unit for each product.
Note that the sales mix percentages are based on the unit sales of each product as a percentage of total sales.
The final step is to divide total fixed costs by the weighted-average CM per unit.
Assumptions of the CVP Analysis
SUMMARY
1. Costvolumeprofit (CVP) analysis is based on a simple model of how contribution margin (CM) and
operating income respond to changes in selling prices, costs, and vol- ume. The analysis is based on the
contribution income statement approach and requires a detailed understanding of cost behaviour. [LO1]
2. A CVP graph depicts the relationships between sales volume in units and fixed expenses, variable
expenses, total expenses, total sales, and profits. The CVP graph is useful for de- veloping intuition
about how costs and profits respond to changes in sales volume. [LO2]
3. The CM ratio is the ratio of the total CM to total sales. This ratio can be used to estimate the effect of a
change in total sales on operating income. [LO3]
4. The techniques of CVP analysis can be used to estimate the effects on CM and operating profit of
changes to sales volume, fixed costs, variable costs per unit, and selling prices. A useful aspect of the
analysis is that managers can evaluate the profit impact of the trade- offs inherent to many operating
decisions, such as increasing advertising costs to boost sales volumes. [LO4]
5. The break-even point is the level of sales (in units or in dollars) at which the company generates zero
profits. The break-even point can be computed using several different tech- niques that are all based on
the simple profit equation. [LO5]
6. The profit equation can also be used to compute the level of sales required to attain a target profit. [LO6]
7. The margin of safety is the amount by which the companys current sales exceed break- even sales.
[LO7]
8. The degree of operating leverage measures the effect of a percentage change in sales on the companys
operating income. The higher the degree of operating leverage, the more sensitive operating income will
be to a change in sales. The degree of operating leverage is not constantit depends on the companys
current level of sales. [LO8]
9. The profits of a multi-product company are affected by its sales mix. Changes in the sales mix can affect
the break-even point, margin of safety, and other critical measures. [LO9]