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 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 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? 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? 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? 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: Equation method 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 Selling price is constant Costs are linear In multi-product companies, the sales mix is constant In manufacturing companies, inventories not change (units produced = units sold) ... 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 50 0 600 700 800 The concept of... 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 50 0... currently total $6,000 per month, and (2) increases unit sales from 50 0 to 57 5 bikes? If Klatch has an opportunity to sell 150 bikes to a wholesaler without disturbing sales to other customers