bg management accounting chapter 5 3736

CHAPTER 5

Cost – Volume – Profit
Relationships (CVP)


5.1 . The Basic concepts
5.1.1. Contribution Margin (CM)
Contribution Margin (CM) is the amount remaining from sales
revenue after variable cost have been deducted.

CM = Total sales revenue – Total Variable cost
Contribution margin per unit equals sales price per unit minus
variable costs per unit or it can be calculated by dividing total
contribution margin by total units sold.


Contribution Income statement
Total
Sales
Less: Variable
expenses
Contribution Margin
Less: Fixed expenses
Net income

Per unit

Percentage

5.1.2. Contribution Margin Ratio
Contribution margin ratio (CMR) equals contribution margin
expressed as a percentage of total sales.
Contribution margin is the amount by which sales revenue
exceeds total variable costs. It calculates what percentage of
sales revenue is available to cover the fixed costs of a business
and yield a profit.


5.1.2. Contribution Margin Ratio
The contribution margin ratio is:

CM Ratio =

Total CM
Total sales

Ex: For Racing Bicycle Company the ratio is:

$80,000
= 40%
$200,000
Meaning of CMR: Each $1.00 increase in sales results in a
total contribution margin increase of 40¢.


5.1.3. Cost Structure
Cost structure refers to the relative proportion of fixed and
variable costs in an organization.
Managers often have some latitude in determining their

organization’s cost structure.


5.1.3. Cost Structure
There are advantages and disadvantages to high fixed cost (or
low variable cost) and low fixed cost (or high variable cost)
structures.
An advantage of a high fixed
cost structure is that income
will be higher in good years
A disadvantage of a high fixed
compared to companies
cost structure is that income
with lower proportion of
will be lower in bad years
fixed costs.
compared to companies
with lower proportion of
fixed costs.


d. Operating Leverage
Operating leverage is: A measure of how sensitive net operating
income is to percentage changes in sales.
Degree of operating leverage is a measure of the extent of operating
leverage
Degree of operating leverage is the multiple by which operating
income of a business changes in response to a given percentage
change in sales.

d. Operating Leverage
Degree of
operating leverage =

Percentage change in net
income
Percentage change in sale

Degree of
operating leverage =

Contribution margin
Net operating income


5.2. Application CVP concepts
ÒAt Klatch Inc, the average selling price of a bike is $250,
the average variable expense per bike is $150, and the
average fixed expense per month is $35,000. 500 bikes
are sold each month on average.
ÒSale Department proposes to the manager some options
for the next month:


5.2. Application CVP concepts
1. What is the profit impact if Klatch increases variable costs per unit by
$10, to generate an increase in unit sales from 500 to 580?
2. What is the profit impact if Racing (1) cuts its selling price $20 per unit, (2)
increases its advertising budget by $15,000 per month, and (3) increases unit

sales from 500 to 650 units per month?
3. What is the profit impact if Racing (1) pays a $15 sales commission per
bike sold instead of paying sales person flat salaries that currently total
$6,000 per month, and (2) increases unit sales from 500 to 575 bikes?
4. If Klatch has an opportunity to sell 150 bikes to a wholesaler without
disturbing sales to other customers or fixed expenses, what price would it
quote to the wholesaler if it wants to increase monthly profits by $3,000?


5.3. Break- Even Point and target profit
Analysis
Break- even analysis can be approached
in two ways:

1. Equation method
2. Contribution margin method


Equation Method
Profits = (Sales – Variable expenses) – Fixed expenses
OR
Sales = Variable expenses + Fixed expenses + Profits

At the break-even point, profits equal zero


CVP Graph
450,000
400,000

a
e
r
tA
i
f
P ro

350,000

Dollars

300,000
250,000
200,000
150,000

ss
o
L a
Are

100,000
50,000
-

100

200

300

400

Units

500

600

700

800


The concept of Sales Mix
• Sales mix is the relative proportion in which a company’s
products are sold.
• If a company sells more than one product, break-even
analysis is more complex. The reason is that different
products will have different selling prices, different costs, and
different contribution margins.
• Consequently, the break-even point depends on the mix in
which

the

various

products

are

sold.


Key Assumptions of CVP Analysis
ΠSelling price is constant.
 Costs are linear.
Ž In multi-product companies, the sales mix is constant.
 In manufacturing companies, inventories do not
change (units produced = units sold).