The term cost structure refers to the relative proportion of and costs in an organization.
3. Use the contribution margin ratio (CM ratio) to compute changes in contribution margin and net operating income resulting from changes in sales volume. Show 4. Show the effects on contribution margin of changes in variable costs, fixed costs, selling price, and volume. 5. Compute the break-even point in unit sales and sales dollars. 6. Determine the level of sales needed to achieve a desired target profit. 7. Compute the margin of safety and explain its significance. 8. Compute the degree of operating leverage at a particular level of sales, and explain how the degree of operating leverage can be used to predict changes in net operating income. 9. Compute the break-even point for a multiple product company and explain the effects of shifts in the sales mix on contribution margin and the break-even point. Chapter Overview A. The Basics of Cost-Volume-Profit (CVP) Analysis. Cost-volume-profit (CVP) analysis is a key step in many decisions. CVP analysis involves specifying a model of the relations among the prices of products, the volume or level of activity, unit variable costs, total fixed costs, and the sales mix. This model is used to predict the impact on profits of changes in those parameters.
B. Some Applications of CVP Concepts. CVP analysis is typically used to estimate the impact on profits of changes in selling price, variable cost per unit, sales volume, and total fixed costs. CVP analysis can be used to estimate the effect on profit of a change in any one (or any combination) of these parameters. A variety of examples of applications of CVP are provided in the text. C. CVP Relationships in Graphic Form. CVP graphs can be used to gain insight into the behavior of expenses and profits. The basic CVP graph is drawn with dollars on the vertical axis and unit sales on the horizontal axis. Total fixed expense is drawn first and then variable expense is added to the fixed expense to draw the total expense line. Finally, the total revenue line is drawn. The total profit (or loss) is the vertical difference between the total revenue and total expense lines. The break-even occurs at the point where the total revenue and total expenses lines cross. D. Break-Even Analysis and Target Profit Analysis. Target profit analysis is concerned with estimating the level of sales required to attain a specified target profit. Break-even analysis is a special case of target profit analysis in which the target profit is zero.
Price x Unit sales = Unit variable cost x Unit sales + Fixed expenses + Profits Unit contribution margin x Unit sales = Fixed expenses + Profits Unit sales =
Sales = Variable expense ratio x Sales + Fixed expenses + Profits (1 - Variable expense ratio) x Sales = Fixed expenses + Profits Contribution margin ratio* x Sales = Fixed expenses + Profits Sales = * 1 - Variable expense ratio = 1 -
Break-even unit sales = =
Break-even sales = =
Unit sales to attain target profits = Dollar sales to attain target profits =
E. Margin of Safety. The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales. It is the amount by which sales can drop before losses begin to be incurred. The margin of safety can be computed in terms of dollars: Margin of safety in dollars = Total sales – Break-even sales or in percentage form: Margin of safety percentage = F. Cost Structure. Cost structure refers to the relative proportion of fixed and variable costs in an organization. Understanding a company’s cost structure is important for decision-making as well as for analysis of performance. G. Operating Leverage. Operating leverage is a measure of how sensitive net operating income is to a given percentage change in sales.
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H. Structuring Sales Commissions. Students may have a tendency to overlook the importance of this section due to its brevity. You may want to discuss with your students how salespeople are ordinarily compensated (salary plus commissions based on sales) and how this can lead to dysfunctional behavior. For example, would a company make more money if its salespeople steered customers toward Model A or Model B as described below? PriceVariable costUnit CM Which model will salespeople push hardest if they are paid a commission of 10% of sales revenue? I. Sales Mix. Sales mix is the relative proportions in which a company’s products are sold. Most companies have a number of products with differing contribution margins. Thus, changes in the sales mix can cause variations in a company’s profits. As a result, the break-even point in a multi-product company is dependent on the sales mix.
Overall CM ratio = 2. Use of the overall CM ratio. The overall contribution margin ratio can be used in CVP analysis exactly like the contribution margin ratio for a single product company. For a multi-product company the formulas for break-even sales dollars and the sales required to attain a target profit are: Break-even sales = Sales to achieve target profits =
J. Assumptions in CVP Analysis. Simple CVP analysis relies on simplifying assumptions. However, if a manager knows that one of the assumptions is violated, the CVP analysis can often be easily modified to make it more realistic.
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