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Learning Objectives:

1 Explain how changes in activity contribution margin and profit

Compute the contribution margin ratio (CM ratio) and use it to compute changes in
2 contribution margin and profit
Show the effects on contribution margin of changes in variable costs, fixed costs,
3 selling price, and volume
Compute the break-even point by both the equation method and the contribution
4 margin method
Prepare a cost-volume-profit (CVP) graph and explain the significance of each of its
5 components
Use the CVP formulas to determine the activity level needed to achieve a desired
6 target profit

7 Compute the margin of safety and explain its significance

Compute the degree of operating leverage at a particular level of sales and explain
8 how the degree of operating leverage can be used to predict changes in profit
Compute the break-even point for a multiple product company and explain the
9 effects of shift in the sales mix on contribution margin and the break-even point.

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CVP analysis is one of the most powerful tools that managers have at their command.
CVP analysis helps them understand the interrelationship between cost, volume and
profit in an organization by focusing on interactions between the following five
elements:

Prices of products
Volume or level of activity
Per unit variable costs
Total fixed costs
Mix of products sold

Because CVP analysis helps managers understand the relationship between cost,
volume and profit, it is a vital tool in many business decisions. These decisions include,
for example, what products to manufacture or sell, what pricing policy to follow, what
marketing strategy to employ, and what type of productive facilities to acquire.

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The basics of cost-volume-profit (CVP) analysis

Acoustic Concepts Ltd

Contribution profir and loss account
For the month of June 2016

Total Per unit

Sales (400 speakers) 100,000 250
Less variable expenses 60,000 150
Contributionmargin 40,000 100
Less fixed expenses 35,000
Profit 5,000

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Contribution Margin

Contribution margin is the amount remaining from sales revenue after variable
expenses have been deducted. Thus, it is the amount available to cover fixed expenses
and then to provide profits for the period.

So, contribution margin is used first to cover fixed expenses, and then whatever
remains goes toward profits.

If the contribution margin is not sufficient to cover the fixed expenses, then a loss
occurs for the period.

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Contribution Margin

Assume that by the middle of a particular month Acoustic Concepts has been able to
sell only one speaker. At that point, the companys profit and loss account will appear
as follows:
Total Per unit
Sales (1 speaker) 250 250
Less variable expenses 150 150
Contributionmargin 100 100
Less fixed expenses 35,000
Profit (34,900)

For each additional speaker that the company is able to sell during the month, Tk. 100
more in contribution margin is available to help cover the fixed expenses.

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Contribution Margin
If a second speaker is sold, for example, then the total contribution margin will
increase by Tk. 100 (a total of Tk. 200) and the companys loss will decrease by Tk. 100
to Tk. 34,800.

Total Per unit

Sales (2 speakers) 500 250
Less variable expenses 300 150
Contributionmargin 200 100
Less fixed expenses 35,000
Profit (34,800)

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Contribution Margin
If enough speakers can be sold to generate Tk. 35,000 in contribution margin, then all
of the fixed costs will be covered and the company will have managed to at least break-
even for the month-that is, to show neither profit nor loss but just cover all of its costs.

Total Per unit

Sales (350 speakers) 87,500 250
Less variable expenses 52,500 150
Contributionmargin 35,000 100
Less fixed expenses 35,000
Profit -

Once the break-even point has been reached, profit will increase by the unit
contribution margin for each additional unit sold.

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Contribution Margin
If 351 speakers are sold in a month, for example, then we can expect that the profit for
the month will be Tk. 100, since the company will have sold one speaker more than the
number needed to break-even:

Total Per unit

Sales (351 speakers) 87,750 250
Less variable expenses 52,650 150
Contributionmargin 35,100 100
Less fixed expenses 35,000
Profit 100

If 352 speakers are sold (2 speakers above the break-even point), then we can expect
that the profit for the month will be Tk. 200 and so forth.

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Contribution Margin
To illustrate, if Acoustic Company is currently selling 400 speakers per month and plans
to increase sales to 425 speakers per month, the anticipated impact on profits can be
computed as follows:

Increased number of speakers to be sold 25

Contribution margin per speaker *100
Increase in profit 2500

These calculations can be verified as follows:

Sales volume
Difference
400 speakers 425 speakers Per unit
25 speakers
Sales 100,000 106,250 6,250 250
Less variable expenses 60,000 63,750 3,750 150
Contributionmargin 40,000 42,500 2,500 100
Less fixed expenses 35,000 35,000 -
Profit 5,000 7,500 2,500

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Contribution Margin Ratio (CM ratio)
In addition to being expressed on a per unit basis, sales revenue, variable expenses,
and contribution margin for Acoustic Concepts can also be expressed as a percentage
of sales:

Percentage
Total Per unit
of sales
Sales (400 speakers) 100,000 250 100.00%
Less variable expenses 60,000 150 60.00%
Contributionmargin 40,000 100 40.00%
Less fixed expenses 35,000
Profit 5,000

The contribution margin as a percentage of total sales is referred to as the contribution

margin ratio (CM ratio). This ratio can be computed as follows:
Contribution margin
CM ratio =
Sales

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Contribution Margin Ratio (CM ratio)
For Acoustic Concepts, the computations are as follows:

Total contribution margin, Tk. 40,000

CM ratio = = 40%
Total sales, Tk. 100,000
or
Per unit contribution margin, Tk. 100
CM ratio = = 40%
Per unit sales, Tk. 250

The CM ratio is extremely useful since it shows how the contribution margin will be
affected by a change in total sales. Acoustic Concepts has a CM ratio of 40%. This means
that for each Tk. Increase in sales, total contribution margin will increase by 40 paisa
(Tk. 1 sales* CM ratio of 40%). Profit will also increase by 40 paisa, assuming that there
are no changes in fixed costs.

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Contribution Margin Ratio (CM ratio)
If Acoustic Concepts plans a Tk. 30,000 increase in sales during the coming month, for
example, management can expect contribution margin to increase by Tk. 12,000 (Tk.
30,000 increased sales* CM ratio of 40%). As fixed cost do not change, profit will also
increase by Tk. 12,000.

This is verified by the following table:

Sales volume
Percentage
400 speakers 425 speakers Increase
of sales
Sales 100,000 130,000 30,000 100.00%
Less variable expenses 60,000 78,000 18,000 60.00%
Contributionmargin 40,000 52,000 12,000 40.00%
Less fixed expenses 35,000 35,000 -
Profit 5,000 17,000 12,000

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Some Applications of CVP Concepts

Percentage
Per unit
of sales
Sales 250 100%
Less variable expenses 100 60%
Contributionmargin 150 40%

Fixed expenses are Tk. 35,000 per month.

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Change in fixed cost and sales volume
Acoustic Concepts is currently selling 400 speakers per month (monthly sales of Tk.
100,000). The sales manager feels that a Tk. 10,000 increase in the monthly advertising
budget would increase monthly sales by Tk. 30,000. Should the advertising budget be
increased?

The following table shows the effect of the proposed change in monthly advertising
budget:

Sales with
Current Advertising Percentage
additional
Sales budget of sales
difference
Sales 100,000 130,000 30,000 100.00%
Less variable expenses 60,000 78,000 18,000 60.00%
Contributionmargin 40,000 52,000 12,000 40.00%
Less fixed expenses 35,000 45,000 10,000
Profit 5,000 7,000 2,000

Tk. 35,000 plus additional Tk. 10,000 monthly advertising budget = Tk. 45,000

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Change in fixed cost and sales volume

Assuming there are no other factors to be considered, the increase in the advertising
budget should be approved since it would lead to an increase in profit of Tk. 2,000.

There are two shorter ways to present this solution.

Expected total contribution margin: 52,000

Tk. 130,000*40% CM ratio
Present total contribution margin: 40,000
Tk. 100,000*40% CM ratio
Incremental contribution margin 12,000
Change in fixed costs:
Less incremental advertising expense 10,000
Increased profit 2,000

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Change in fixed cost and sales volume

Since, in this case, only fixed costs and the sales volume change, the solution can be
presented in an even shorter format, as follows:

Incremental contribution margin 12,000

Tk. 30,000*40% CM ratio
Less incremental advertising expense 10,000
Increased profit 2,000

Both the solutions above involve an incremental analysis in that they consider only
those items of revenue, cost and volume that change if the new programme is
implemented.

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Change in variable cost and sales volume
Acoustic Concepts is currently selling 400 speakers per month. Management is
contemplating the use of higher-quality components, which would increase variable
costs (and thereby reduce the contribution margin) by Tk. 10 per speaker. However, the
sales manager predicts that the higher overall quality would increase sales to 480
speakers per month.

Should the higher-quality components be used?

The Tk. 10 increase in variable costs will cause the unit contribution margin to decrease
from Tk. 100 to Tk. 90. So the solution is:

Expected total contribution margin with higher-quality components: 43,200

480 speakers*Tk. 90
Present total contribution margin: 40,000
480 speakers*Tk. 100
Incremental contribution margin 3,200

Yes, based on the information above, the higher quality components should be used.
Since fixed costs will not change, profit should increase by the Tk. 3,200 increase in
contribution margin shown above.

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Change in fixed cost, sales price and sales volume
Again the company is currently selling 400 speakers per month. To increase sales, the
sales manager would like to cut the selling price by Tk. 20 per speaker and increase the
advertising budget by Tk. 150,000.

The sales manager argues that if these two steps are taken, unit sales will increase by
50% to 600 speakers per month.

Should the changes be made?

A decrease of Tk. 20 per speaker in the selling price will cause the unit contribution
margin to decrease from Tk. 100 to Tk. 80. The solution is:
Expected total contribution margin with lowering selling price: 48,000
600 speakers * Tk. 80
Present total contribution margin: 40,000
400 speakers * Tk. 100
Incremental contribution margin 8,000
Change in fixed costs:
Less incremental advertising expense 15,000
Reduction in profit profit (7,000)

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Change in fixed cost, sales price and sales volume

No, based on the information above, the changes should not be made. The same
solution can be obtained by preparing comparative profit and loss accounts:

Present 400 speakers per month Expected 600 speakers per month Difference
Total Per unit Total Per unit
Sales 100,000 250 138,000 230 38,000
Less variable expenses 60,000 150 90,000 150 30,000
Contributionmargin 40,000 100 48,000 80 8,000
Less fixed expenses 35,000 50,000 15,000
Profit 5,000 (2,000) (7,000)

Tk. 35,000+ Additional monthly advertising budget of Tk. 15,000 = Tk. 50,000

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Change in variable cost, fixed cost, and sales volume

Again the company is currently selling 400 speakers per month. To increase sales, the
sales manager would like to place the sales staff on a commission basis of Tk. 15 per
speaker sold, rather than on flat salaries that now total Tk. 6,000 per month. The sales
manager is confident that the change will increase monthly sales by 15% to 460
speakers per month.

Should the change be made?

Changing the sales staff from a salaried basis to a commission basis will affect both
fixed and variable costs. Fixed costs will decrease by Tk. 6,000, from Tk. 35,000 to Tk.
29,000. Variable costs will increase by Tk. 15, from Tk. 150 to Tk. 165, and the unit
contribution margin will decrease from Tk. 100 to Tk. 85

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Change in variable cost, fixed cost, and sales volume
Expected total contribution margin with sales staff on commissions: 39,100
460 speakers * Tk. 85
Present total contribution margin: 40,000
400 speakers * Tk. 100
Decrease in total contribution margin (900)
Change in fixed costs:
Add salaries avoided if a commission is paid 6,000
Increase in profit 5,100

Yes, based on the information above, the changes should be made. Again, the same
answer can be obtained by preparing comparative profit and loss accounts:

Present 400 speakers per month Expected 460 speakers per month Difference
Total Per unit Total Per unit
Sales 100,000 250 115,000 250 15,000
Less variable expenses 60,000 150 75,900 165 15,900
Contributionmargin 40,000 100 39,100 85 (900)
Less fixed expenses 35,000 29,000 (6,000)
Profit 5,000 10,100 5,100

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Change in regular sales price
Again the company is currently selling 400 speakers per month. The company has an
opportunity to make a bulk sales of 150 speakers to a wholesaler if an acceptable price
can be worked out. This sale would not disturb the companys regular sales.

What price per speaker should be quoted to the wholesaler if Acoustic Concepts wants
to increase its monthly profits by Tk. 3,000? The solution is:

Variable cost per speaker 150

Desired profit per speaker
Tk. 3,000/150 speakers 20
Quoted price per speaker 130

Notice that no element of fixed cost is included in the computation. This is because
fixed costs are not affected by the bulk sale, so all additional revenue in excess of
variable costs goes to increasing the profits of the company.

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Break-even Analysis

The break-even point is the level of sales at which profits are zero. It can also be
defined as the point where total revenue equals total cost, and as the point where total
contribution margin equals total fixed cost.

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Break-even Computations

The break-even point can be computed using the following the methods:

The equation method

The contribution margin method

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The Equation method for Break-even Computations

The equation method centers on the contribution approach to the profit and loss
account. The format of this profit and loss account can be expressed in equation form
as follows:
Profit = Sales - (Variable expenses + Fixed expenses)

Rearranging this equation slightly yields the following equation, which is widely used
in CVP analysis:
Sales = Variable expenses + Fixed expenses + Profits

At the break-even point, profits are zero. Therefore, the break-even point can be
computed by finding that point where sales just equal the total of the variable
expenses plus the fixed expenses.

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The Equation method for Break-even Computations

For Acoustic Concepts, the break-even point in unit sales, Q, can be computed as
follows:
Sales = Variable expenses + Fixed expenses + Profits

250Q = 150Q + 35000 + 0

100Q = 35000
Q = 35000/100
Q = 350 speakers
Where:
Q = Number (quantity) of speakers sold
Tk. 250 = Unit sales price
Tk. 150 = Unit variable expenses
Tk. 35,000 = Total fixed expenses
The break-even point in sales can be computed by multiplying the break-even level of
unit sales by the selling price per unit:
350 speakers * 250 = Tk. 87,500

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The Equation method for Break-even Computations

The break-even in total sales Tk. X, can also be directly computed as follows:
Sales = Variable expenses + Fixed expenses + Profits
X = .60 X + 35,000 + 0
.40 X = 35,000
X = 35,000/.40
X = 87,500
Where:
X = Total sales
0.60 = Variable expenses as a percentage of sales
35,000 = Total fixed expenses

Firms often have data available only percentage from, and the approach we have just
illustrated must then be used to find the break-even point. Notice that use of
percentages in the equation yields a breakeven point in sales rather than in units sold.
The breakeven point in units sold is the following:
87,500 = 250 * 350 speakers

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The Contribution method for Break-even Computations
The contribution method is actually just a short-cut version of the equation method.
The approach centers the idea that each unit sold provides a certain amount of
contribution margin that goes towards covering fixed costs. To find how many units
must be sold to break-even, divide the total fixed costs by the unit contribution margin.
Break-even points in units sold = Fixed expenses / Unit contribution margin
Each speaker generates a contribution margin of Tk. 100 (Tk. 250 selling price, less Tk.
150 variable expenses). Since the total fixed expenses are Tk. 35,000, the break-even
point is as follows:
(Fixed expenses / Unit contribution margin) = (35,000/ 100) = 350 speakers.
A variation of this method uses the CM ratio instead of the unit contribution margin.
The result is the break-even in total sales Tk. rather than in total units sold.
Break-even point in total sales = Fixed expenses / CM ratio
In the Acoustic Concepts example, the calculations are as follows:
Fixed expenses / CM ratio = 35,000/40% = 87,500
This approach, based on CM ratio, is particularly useful in those situations where a
company has multiple product lines and wishes to compute a single break-even point
for the company as a whole.

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CVP relationships in graphic form

The relationships among revenue, cost, profit and volume can be expressed graphically
by preparing a Cost-Volume-Profit (CVP) graph. A CVP graph highlights CVP
relationships over wide ranges of activity and can give managers a perspective that can
be obtained in no other way.

Preparing the CVP graph:

Preparing the CVP graph (sometimes called a breakeven chart) involve three steps:

Draw a line parallel to the volume axis to represent total fixed expenses
Choose some volume of sales and plot the point representing total expenses (fixed
and variable) at the activity level.
Choose some volume of sales and plot the point representing total sales Tk. At the
activity level.

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Target Profit Analysis

CVP formulas can be used to determine the sales volume needed to achieve a target
profit. Suppose that, the managing director of Acoustic Concepts would like to earn a
target profit of Tk. 40,000 per month. How many speakers would have to be sold?

The CVP Equation approach

Sales = Variable expenses + Fixed expenses + Profits
250 Q = 150 Q + 35,000 + 40,000
100 Q = 75,000
Q = 75,000 / 100
Q = 750 speakers
Where:
Q = Number of speakers sold
Tk. 250 = Unit sales price
Tk. 150 = Unit variable expenses
Tk. 35,000 = Total fixed expenses
Tk. 40,000 = Target Profit

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Target Profit Analysis

Thus, the target profit can be achieved by selling 750 speakers per month, which
represents Tk. 87,500 in total sales (Tk. 250 * 750 speakers)

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Target Profit Analysis

The Contribution Approach

A second approach involves expanding the contribution margin formula to include the
target profit:

Units sold to attain the target profit = (Fixed expenses + Target profit ) / Unit
contribution margin
= Tk. 35,000 Fixed expenses + Tk. 40,000
target profit )/ Tk. 100 contribution margin per
speaker.
= 750 speakers.

This approach gives the same answer as the equation method since it is simply a short-
cut version of the equation method.

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The margin of Safety
The margin of safety is the excess of budgeted (or actual) sales over the break-even
volume of sales. It states the amount by which sales can drop before losses begin to be
incurred. The formula for its calculation is as follows:

Margin of safety = Total budgeted (or actual ) sales Break-even sales

The margin of safety can also be expressed in percentage form. This percentage is
obtained by dividing the margin of safety in Tk. Terms by total sales:

Sales (at the current volume of 400 speakers) (a) 100,000

(400 speakers * Tk. 250 per speaker)
Break-even sales (at 350 speakers) (b) 87,500
(350 speakers * Tk. 250 per speaker)
Margin of safety (in Tk.) 12,500
Margin of safety as a percentage of sales (c/a) 12.50%

This margin of safety means that at the current level of sales and with the copays
current prices and cost structure, a reduction in sales of Tk. 12,500, or 12.5%, would
result in just braking even.

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CVP considerations in choosing a cost structure

Cost structure refers to the relative proportion of fixed and variable costs in an
organization. An organization often has some latitude in trading off between fixed and
variable costs by automating facilities rather than using direct labor hours.

Cost structure and profit stability

When a manager has some latitude in trading off between fixed and variable costs,
which cost structure is better-high variable costs and low fixed costs, or the opposite?
No categorical answer to this question is possible; there may be advantages either way,
depending on the specific circumstances.

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Cost structure and profit stability
Bogside Farm depends on migrant workers to pick its berries by hand, where Sterling
Farm has invested in expensive berry-picking machines. Consequently, Bogside Farm
has higher variable costs, but Sterling Farm has higher fixed costs:

Bogside Farm Sterling Farm

Amount Percentage Amount Percentage
Sales 100,000 100% 100,000 100%
Less variable expenses 60,000 60% 30,000 30%
Contributionmargin 40,000 40% 70,000 70%
Less fixed expenses 30,000 60,000
Profit 10,000 10,000

The question as to which Farm has the better cost structure depends on many factors,
including the long-run trend in sales, year-to-year fluctuations in the level of sales, and
the attitude of the owners toward risk.
If sales are expected to be above Tk. 100,000 in the future, then Sterling Farm probably
has the better cost structure. The reason is that CM ratio is higher, and its profits will
therefore increase more rapidly as sales increase.

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Cost structure and profit stability
Assume that each Farm experiences a 10% increase in sales without any increase in fixed
costs. The new profit and loss accounts would be as follows:

Bogside Farm Sterling Farm

Amount Percentage Amount Percentage
Sales 110,000 110% 110,000 110%
Less variable expenses 66,000 60% 33,000 30%
Contributionmargin 44,000 40% 77,000 70%
Less fixed expenses 30,000 60,000
Profit 14,000 17,000

Sterling Farm has experienced a greater increase in profit due to higher CM ratio even
though the increase in sales was the same for both farms.

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Cost structure and profit stability
What if sales drop below Tk. 100,000 from time to time?
What are breakeven points of the two farms?
What are their margin of safety?
Bogside Farm Sterling Farm
Fixed expenses 30,000 60,000
Contribution margin ratio 40.00% 70.00%
Break-even in total sales Tk. 75,000 85,714
Total current sales (a) 100,000 100,000
Break-even sales 75,000 85,714
Margin of safety in sales Tk. (b) 25,000 14,286
Margin of safety as a percentage of sales, (b)+(a) 25.00% 14.29%

This analysis makes it clear that Bogside Farm is less vulnerable to downturns than Sterling Farm.
We can identify two reasons why it is less vulnerable.
Due to its lower fixed expenses, Bogside Farm has a lower breakeven point and a higher
margin of safety. Therefore, it will not incur losses as quickly as Sterling Farm in periods of
sharply declining sales.
Due to its lower CM ratio, Bogside Farm will not lose contribution margin as rapidly as Sterling
Farm when sales fall off.
Thus Bogside Farms profit will be less volatile. This is a drawback when sales increase, but it
provides more protection when sales drop.

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Operating Leverage

Operating leverage is a measure of how sensitive profit 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 profit.

The degree of operating leverage at a given level of sales is computed by the following
formula:

Contribution margin
Degree of operating leverage =
Profit

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. To illustrate, the degree of
operating leverage for the two farms at a Tk. 100,000 sales level would be as follows:

40,000
Bogside Farm = = 4
10,000
70,000
Sterling Farm = = 7
10,000

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Operating Leverage
Since the degree of operating leverage for Bogside Farm is four, the farms profit
grows four times as fast as its sales. Similarly, Sterling Farms profit grows seven times
as fast as its sales.

Thus, if sales increase by 10%, then we can expect the profit of Bogside Farm to increase
four times this amount, or by 40%, and the profit of Sterling Farm to increase by seven
times this amount, or by 70%.

Percentage Degree of Percentage

increaes in sales operating leverage increase in profit
Bogside Farm 10% 4 40%
Sterling Farm 10% 7 70%

What is responsible for the higher operating leverage at Sterling Farm? The only
difference between the two farms is their cost structure. If two companies have the
same of 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.

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Operating Leverage

The degree of operating leverage is greatest at sales levels near the breakeven point
and decreases as sales and profit rise.

Sales 75,000 80,000 100,000 150,000 225,000

Less variable expenses 45,000 48,000 60,000 90,000 135,000
Contribution margin (a) 30,000 32,000 40,000 60,000 90,000
Less fixed expenses 30,000 30,000 30,000 30,000 30,000
Profit (b) - 2,000 10,000 30,000 60,000
Degree of operating leverage, (a)/(b) 16.00 4.00 2.00 1.50

A manager can use the degree of operating leverage quickly to estimate what impact
various percentage changes in sales will have on profits, without the necessity of
preparing detailed profit and loss accounts. As shown in example, the effects of
operating leverage can be dramatic. If a company is near its breakeven point, then even
small percentage increases in sales can yield large percentage increases in profits. This
explains why management will often work very hard for only a small increase in sales
volume. If the degree of operating leverage is five, then a 6% increase in sales would
translate into a 30% increase in profits.

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Automation: Risks and Rewards from a CVP perspective

Several factors, including the move towards flexible manufacturing systems and other
uses of automation, have resulted in a shift towards greater fixed costs and less variable
costs in organizations. In turn, this shift in cost structure has had an impact on the CM
ratio, the break-even point, and the degree of operating leverage. Some of this impact
has been favorable and some has not.

Many benefits can accrue from automation. Certain risks are introduced when a
company moves towards greater amounts of fixed costs. These risks suggest that
management must be careful as it automates to ensure that investment decisions are
made in accordance with a carefully devised long run strategy.

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Structuring sales commissions
Companies generally reward salespersons by paying them either a commissions based
on sales or a salary plus a sales commission. Commissions based on sales Tk. Can lead to
lower profits in a company.

Consider Pipeline Unlimited, a producer of surfing equipment. Salesperson for the

company sell the companys product to retail sporting goods stores throughout Asia.
Data for two of the companys surfboards, the XR7 and Turbo models, appear below:
Model XR7 Turbo
Selling price 100 150
Less variable expenses 75 132
Contribution margin 25 18

Which model will salespersons push hardest if they are paid a commission of 10% of sales
revenue?
The answer, clearly, is the Turbo, since it has the higher selling price.

On the other hand, from the standpoint of the company, profit will be greater if
salespeople steer customers toward the XR7 model since it has the higher contribution
margin.

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Structuring sales commissions

To eliminate such conflicts, some companies base salespersons commissions on

contribution margin rather than on sales. The reasoning goes like this:

Since contribution margin represents the amount of sales revenue available to cover
fixed expenses and profits, a firms well-being will be maximized when contribution
margin is maximized. By typing salespersons commissions to contribution margin, the
salespersons are automatically encouraged to concentrate on the element that is of
most importance to the firm. There is no need to worry about what mix of products the
salespersons sell because they will automatically sell the mix of the products that will
maximize the contribution margin. In effect, by maximizing their own well-being, they
automatically maximize the well-being of the firm-assuming there is no change in fixed
expenses.

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The concept of Sales Mix

The term sales mix refers to the relative proportions in which a companys products are
sold. The idea is to achieve the combination, or mix, that will yield the greatest amount
of profits. Most companies have many products, and often these products are not
equally profitable. Hence, profits will depend to some extent on the companys sales
mix. Profits will be greater if high-margin rather than low-margin items make up a
relatively large proportion of total sales.

Changes in the sales mix can cause interesting variations in a companys profits. A shift
in the sales mix from high-margin items to low-margin items can cause total profits to
decrease even though total sales may increase. Conversely, a shift in the sales mix from
low-margin items to high-margin items can cause the reverse effecttotal profits may
increase even though total sales decrease. It is one thing to achieve a particular sales
volume; it is quite another to sell the most profitable mix of products.

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Sales Mix and Break-Even Analysis

If a company sells more than one product, break-even analysis is more complex than
discussed to this point. 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.

Consider Virtual Journeys Unlimited, a small company that imports DVDs from France.
At present, the company sells two DVDs: the Le Louvre DVD, a tour of the famous art
museum in Paris; and the Le Vin DVD, which features the wines and wine-growing
regions of France. The companys September sales, expenses, and break-even point
are shown in below:.

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As shown in the exhibit, the break-even point is $60,000 in sales, which was computed
by dividing the companys fixed expenses of $27,000 by its overall CM ratio of 45%.
However, this is the break-even only if the companys sales mix does not change.
Currently, the Le Louvre DVD is responsible for 20% and the Le Vin DVD for 80% of the
companys dollar sales. Assuming this sales mix does not change, if total sales are
$60,000, the sales of the Le Louvre DVD would be $12,000 (20% of $60,000) and the sales
of the Le Vin DVD would be $48,000 (80% of $60,000). As shown in Exhibit, at these
levels of sales, the company would indeed break even. But $60,000 in sales represents
the break-even point for the company only if the sales mix does not change.

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If the sales mix changes, then the break-even point will also usually change. This is
illustrated by the results for October in which the sales mix shifted away from the more
profitable Le Vin DVD (which has a 50% CM ratio) toward the less profitable Le Louvre
CD (which has a 25% CM ratio). Although sales have remained unchanged at $100,000,
the sales mix is exactly the reverse of what it was in Exhibit , with the bulk of the sales
now coming from the less profitable Le Louvre DVD. Notice that this shift in the sales
mix has caused both the overall CM ratio and total profits to drop sharply from the
prior month even though only 30% in October, and net operating income has dropped
from $18,000 to only $3,000. In addition, with the drop in the overall CM ratio, the
companys break-even point is no longer $60,000 in sales. Because the company is now
realizing less average contribution margin per dollar of sales, it takes more sales to
cover the same amount of fixed costs. Thus, the break-even point has increased from
$60,000 to $90,000 in sales
per year.

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Assumptions of CVP Analysis

A number of assumptions commonly underlie CVP analysis:

Selling price is constant. The price of a product or service will not change as volume
changes.
Costs are linear and can be accurately divided into variable and fixed elements. The
variable element is constant per unit, and the fixed element is constant in total over
the entire relevant range.
In multiproduct companies, the sales mix is constant.
In manufacturing companies, inventories do not change. The number of units
produced equals the number of units sold.

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What is meant by a products contribution margin ratio? How is

this ratio useful in planning business operations?

The contribution margin (CM) ratio is the ratio of the total contribution margin to total
sales revenue. It can be used in a variety of ways. For example, the change in total
contribution margin from a given change in total sales revenue can be estimated by
multiplying the change in total sales revenue by the CM ratio. If fixed costs do not
change, then a dollar increase in contribution margin will result in a dollar increase in net
operating income. The CM ratio can also be used in break-even analysis. Therefore, for
planning purposes, knowledge of a products CM ratio is extremely helpful in
forecasting contribution margin and net operating income.

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Often the most direct route to a business decision is an

incremental analysis. What is meant by an incremental analysis?

Incremental analysis focuses on the changes in revenues and costs that will result from a
particular action.

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In all respects, Company A and Company B are identical except that Company
As costs are mostly variable, whereas Company Bs costs are mostly fixed.
When sales increase, which company will tend to realize the greatest increase
in profits? Explain.

All other things equal, Company B, with its higher fixed costs and lower variable costs,
will have a higher contribution margin ratio. Therefore, it will tend to realize the most
rapid increase in contribution margin and in profits when sales increase.

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What is meant by the term operating leverage?

Operating leverage measures the impact on net operating income of a given percentage
change in sales. The degree of operating leverage at a given level of sales is computed
by dividing the contribution margin at that level of sales by the net operating income.

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A 10% decrease in selling price of a product will have the same impact on profit
as a 10% increase in the variable expense. Do you agree? Why or Why not?

No. A 10% decrease in the selling price will have a greater impact on profits than a 10%
increase in variable expenses, since the selling price is a larger figure than the variable
expenses. Mathematically, the same percentage applied to a larger base will yield a
larger result. In addition, the selling price affects how much of the product will be sold.

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What is meant by the term break-even point?

The break-even point is the level of sales at which profits are zero. It can also be defined
as the point where total revenue equals total cost, and as the point where total
contribution margin equals total fixed cost.

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Name three approaches to break-even analysis. Briefly explain how each
approach works.

Three approaches to break-even analysis are (a) the graphical method, (b) the equation
method, and (c) the contribution margin method.

In the graphical method, total cost and total revenue data are plotted on a graph. The
intersection of the total cost and the total revenue lines indicates the break-even point.
The graph shows the break-even point in both units and dollars of sales.

The equation method uses some variation of the equation Sales = Variable expenses +
Fixed expenses + Profits, where profits are zero at the break-even point. The equation is
solved to determine the break-even point in units or dollar sales.

In the contribution margin method, total fixed cost is divided by the contribution margin
per unit to obtain the break-even point in units. Alternatively, total fixed cost can be
divided by the contribution margin ratio to obtain the break-even point in sales dollars.

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In response to a request from your immediate supervisor, you have prepared a

CVP graph portraying the cost and revenue characteristics of your companys
product and operations. Explain how the lines on the graph and the break-even
point would change if ( a ) the selling price per unit decreased, ( b ) fixed cost
increased throughout the entire range of activity portrayed on the graph, and
( c ) variable cost per unit increased.

(a) If the selling price decreased, then the total revenue line would rise less steeply,
and the break-even point would occur at a higher unit volume.
(b) If fixed costs increased, then both the fixed cost line and the total cost line would
shift upward and the break-even point would occur at a higher unit volume.
(c) If the variable costs increased, then the total cost line would rise more steeply and
the break-even point would occur at a higher unit volume.

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What is meant by the margin of safety?

The margin of safety is the excess of budgeted (or actual) sales over the break-even
volume of sales. It states the amount by which sales can drop before losses begin to be
incurred.

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What is meant by the term sales mix? What assumption is usually made
concerning sales mix in CVP analysis?

The sales mix is the relative proportions in which a companys products are sold. The
usual assumption in cost-volume-profit analysis is that the sales mix will not change.

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Explain how a shift in the sales mix could result in both a higher break-even
point and a lower net income.

A higher break-even point and a lower net operating income could result if the sales mix
shifted from high contribution margin products to low contribution margin products.
Such a shift would cause the average contribution margin ratio in the company to
decline, resulting in less total contribution margin for a given amount of sales. Thus, net
operating income would decline. With a lower contribution margin ratio, the break-even
point would be higher since it would require more sales to cover the same amount of
fixed costs.

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