[5] Short-term Decision-Making: Cost-Volume-Profit Analysis Flashcards
What does the Accountant’s Straight-Line
Approximation refer to ?
What is the relevant range?
A straight line closely approximates a curvilinear variable cost line within the relevant range
Relevant range is the range of business activity for which the straight line is an accurate approximation of the Economist’s Curvilinear Cost Function
•CVP analysis helps managers understand
the interrelationship between cost, volume
and profit in an organization by focusing on
interactions between five variables:
- Prices of products
- Volume or level of activity
- Per unit variable costs
- Total fixed costs
- Mix of products sold
What is the contribution margin?
Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted
The break-even point can be defined either as:
The point where total sales revenue equals total expenses (variable and fixed)
The point where total contribution margin equals total fixed expenses
The contribution margin ratio is:
CM ratio = Contribution margin / Sales
At Wind, each £1.00 increase in sales
revenue results in a total contribution margin
increase of 40p
If sales increase by £50,000, what will be the
increase in total contribution margin?
£50,000 × 40% = £20,000
Wind is currently selling 500 bikes per month.
The company’s sales manager believes that
an increase of £10,000 in the monthly
advertising budget would increase bike sales
to 540 units.
Should we authorise the requested increase in
the advertising budget? [slide 33 needed]
Slide 34
Sales increased by £20,000, but net profit
decreased by £2,000
Remember the contribution margin changes as output changes
Wind is contemplating the use of higherquality components, which would increase variable costs (and thereby reduce the contribution margin) by ￡20 per bike. However, the sales manager predicts that the higher overall quality would increase sales to 550 bikes per month. Should the higher-quality components be used? [slide 37]
CM Decrease (500 units X £20) £ 10,000
CM Increase (new sales of 50 units x £180) 9,000
Decrease in net profit £ 1,000
Break-even analysis can be approached in
two ways:
Equation method
Contribution margin method
Equation Method of Break-even analysis:
Profits = Sales – (Variable expenses + Fixed expenses)
Sales = Variable expenses + Fixed expenses + Profits
[At the break-even point profits equal zero] ^^
Break-even point =
in units sold
Break-even point in =
total sales
Break-even point = Fixed expenses /
in units sold Unit contribution margin
Break-even point in = Fixed expenses /
total sales CM ratio
= Fixed expenses /
(Contribution margin / Sales)
What is the CVP equation?
Sales = Variable expenses + Fixed expenses + Profits
Suppose Wind Co. wants to know how
many bikes must be sold to earn a
profit of £100,000?
Per unit Sales: £500
Per unit variable costs : £300
Fixed costs: £80,000
Sales = Variable expenses + Fixed expenses + Profits
£500Q = £300Q + £80,000 + £100,000
£200Q = £180,000
Q = 900 bikes
What is the margin of safety?
Formula?
What is it often expressed as?
Excess of budgeted (or actual) sales over the break-even volume of sales. The amount by which sales can drop before losses begin to be incurred.
Margin of safety = Total sales - Break-even sales
The margin of safety can be expressed as
a % of sales
What is Operating Leverage?
How is it calculated?
What does a higher operating leverage mean?
A measure of how sensitive net profit is to
percentage changes in sales.
Degree of operating leverage = Contribution margin /
Net profit
With high leverage, a small percentage
increase in sales can produce a much larger
percentage increase in net profit
eg: operating leverage of 5, if Wind increases its
sales by 10%, net profit would increase by 50%.
