MBA Accounting & Finance Guide » Cost-Volume-Profit

Re-formating Income Statement into a Contribution Margin Format

slang — Wed, 13 Oct 2010 02:43:54 +0000

For managerial accounting accounting purpose, it is very useful to recast the normal income statement into a contribution margin format. So what is the difference between the normal gross margin format and the contribution margin format.

The difference is self-explanatory -refer to the formula:

Gross margin = Revenues – Cost of Sales

whereas:

Contribution margin = Revenues – Total Variable Cost

Simple illustration of the contribution margin format:

Revenues $500,000

Variable costs 50,000

Contribution margin 450,000

Fixed costs 30,000

Operating Income $420,000

The advantage of the contribution margin format is to provide data for break-even point calculations and cost volume-profit analysis.

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What Do We Mean By Operating Leverage And What Are The Implications

slang — Tue, 29 Sep 2009 15:32:33 +0000

Below article describes the meaning of operating leverage, some of the ratios to measure operating leverage, its application and users and an illustrated example on how to compute operating leverage.

(a) Meaning of Operating Leverage:

Refers to the existence of fixed costs in a company’s cost structure
Is used to measure operating risk

(b) Following ratios being used to measure operating leverage:

Fixed cost/total cost
% change in operating income/percentage change in sales volume or

Change in profit/profit

———————————-

Change in quantity/quantity

Operating leverage are important to managers and financial analysts to understand the degree of operating leverage of a company. A high operating leverage means greater fixed cost committments that have to be met even when sale volume declines [ note that high degrees of operating leverage plus highly elastic product demand will result in high levels of variability in earnings although such a condition may be inherent in the industry like the airline and auto industries.
Note that the effects of operating leverage diminish as revenue increases above the breakeven point, since the bases to wich increases in earnings are compared become progressively larger. Therefore it is important to examine the relationship between sales and the breakeven point
A company with a high breakeven point is quite vulnerable to economic declines. A high ratio of variable cost to total cost indicates greater stability, because variable cost can be adjusted more easily than fixed cost to meet a declin product demand.

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Snapshots Of Articles Under Cost-Volume-Profit(Managerial Accounting)

slang — Thu, 20 Mar 2008 09:18:34 +0000

Append below is a list of articles under Cost-Volume-Profit(Managerial Accounting:

Break-even point in Cost-Volume-Profit

Steps to follow in Using Contribution Margin in the Cost-Volume-Profit Relationship

Cost-Volume-Profit Relationships – Benefits or Objectives

Limitation of Cost-Volume-Profit Analysis In Short Term Decision

Introduction & Assumptions Made in Cost-Volume-Profit

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Break Even Point (BEP) in Cost-Volume-Profit Relationship

slang — Fri, 02 Nov 2007 13:30:55 +0000

Most managers would able to understand the term “break-even” which means there is no loss or gain.

Similarly, in the cost-volume-profit relationship, break even point(BEP) is the LEVEL OF SALES AT WHICH PROFIT IS ZERO. At this point , there is NO gain or loss

Refer to the below situation:

Total ($) Per unit($)

Sales ( 500 Product A) 200,000 550

Less: Variable expenses 50,000 200

Contribution margin 150,000 350

less: Fixed expenses 70,000

Net Operating Income 80,000

Salient points to note:

Once the break even point has been reached, net operating income will increase by the unit contribution margin for each additional unit sold in this case $350
Even if there is no sales, the company loss would equal to its fixed expense which is $70,000
In the above case, there is ample profit, the decision maker can still price the products lower until the contribution margin= fixed expense which is the breakeven point level of sales.

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Steps To Follow Using Contribution Margin In The Cost-Volume-Profit Relationship

slang — Fri, 02 Nov 2007 13:15:56 +0000

As described earlier, managers whether with financial or non-financial knowledge needs to at least understand the cost-volume-profit relationship to make decisions. The steps to remember the main element namely Contribution Margin is very simple & basic:

Contribution Margin(CM) is left after variable expenses have been deducted
CM amount will cover fixed expenses
After covering fixed cost, any remaining CM contributes to income
If CM is not sufficient to cover fixed expenses, we then see a LOSS situation

Append below a simple illustration of a profitable scenario when using the Contribution margin basis:-

ABC Company

Contribution Income Statement For Jan 07

Total ($) Per Unit($)

Sales (500 Product X) 500,000 1,000

less: Variable expenses 300,000 400

Contribution Margin 200,000 600

Less: Fixed expenses 70,000

Net Operating Income 130,000

Notes:

the CONTRIBUTION MARGIN(CM) namely the net operating income is the balance remaining from sales revenue after variable expenses have been deducted
Per Unit column is important to make decision
Note that the above information is only for the internal users and not external parties.

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Cost-Volume-Profit Relationship & Its Objective/Benefits

slang — Fri, 02 Nov 2007 13:07:10 +0000

Cost-volume-profit relationships need to be understood by managers whether who have financial or non financial knowledge. This is because the cost-volume-profit relationship helps manager to make decision. It helps them to understand the interrelation between, cost, volume and profit in an organizatin by focusing interactions among the following elements:

Price of the product
Volume or level of activity
Per unit variable cost
Total fixed cost
Mix of product sold

The aforesaid elements would provide the managers the following answers:

what product to manufacture or sell
what pricing to follow
what marketing strategy to employ
what type of productive facilities to acquire

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Limitation Of Cost Volume Profit Analysis In Short Term Decision

slang — Mon, 15 Oct 2007 16:14:06 +0000

Managers who wish to deploy the Cost-Volume-Profit Analysis effectively, need to also understand some of the following limitations of this modelling tool:

1. Segregation of total costs into its fixed and variable components is difficult to do.

2. Fixed costs are unlikely to stay constant as output increases beyond a certain range of activity.

3. The analysis is restricted to the relevant range specified and beyond that the results can be unreliable

4. Besides volume, other elements like inflation, efficiency, capacity and technology can affect costs

5. Impractical to assume sales mix remain constant since this depend on the changing demand levels.

6. The assumption of linear property of total cost and total revenue relies on the assumption that unit variable cost and selling price are constant. However, this is likely to be valid within relevant range only.

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Cost Volume Profit Analysis

slang — Mon, 15 Oct 2007 16:13:06 +0000

Cost Volume Profit analysis is a short term decision making tool used to assist managers in understanding the behavior of total costs, total revenues and operating income as changes occur in the output level, selling prices, variable cost or fixed costs.

Cost Volume Profit analysis is able to show the impact on the organization profit given different set of sensitivity in selling prices, costs, income tax rates, product mix and others.

Normally Cost Volume Profit analysis involve the Break-even Calculation.

It is important to understand the CVP analysis are based on the following key assumptions:

1. Fixed costs are constant over the output range

2. It is possible to divide costs into fixed and variable elements

3. Variable costs are directly proportional to volume

4. All other variables remain constant.

5. Profits are calculated on marginal-costing basis.

6. All units produced are sold.

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