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[.]

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 Per unit Percentage Sales

Less: Variable

expenses

Contribution Margin

Less: Fixed expenses

Net income

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:

Ex: For Racing Bicycle Company the ratio is:

Total CM Total sales

CM Ratio =

= 40%

$80,000

$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

compared to companies

with lower proportion of

fixed costs

A disadvantage of a high fixed cost structure is that income will be lower in bad years 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

Contribution margin Net operating income

Degree of operating leverage =

Percentage change in net

income Percentage change in sale

Degree of

operating leverage =

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

Profits = (Sales – Variable expenses) – Fixed expenses

OR

Sales = Variable expenses + Fixed expenses + Profits

Equation Method

At the break-even point, profits equal zero

CVP Graph

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

- 100 200 300 400 500 600 700 800

Dolla

Units

rea

Los s Are a

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

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)