Topic 3: Cost-Volume-Profit Analysis

Question 1

Conceptually speaking, what does contribution margin per unit represent? What is the contribution margin formula?

Answer 1

-Conceptually speaking, contribution margin per unit represents how much of our fixed costs we pay down with each additional sale of the product.
-After fixed costs are paid down, contribution margin represents how much additional profit we earn on a per product basis.
-Contribution Margin=Revenue-Variable Costs

Question 2

Compare and contrast gross margin and contribution margin?

Answer 2

-Gross margin is based on the functional classification of costs such as product or period costs.
-Gross margin includes variable product costs which consist of direct materials, direct labor, and variable manufacturing overhead; and of course fixed product costs.
-Contribution margin includes variable product costs which once again consist of direct materials, dierect labor, and variable manufacturing overhead; as well as variable period costs which include Variable General and Admin (VG&A), as well as Variable Marketing and Selling (VM&S).

Question 3

What are operating expenses?

Answer 3

-Operating expenses are period costs that are not part of production.
-Operating expenses are variable period costs, as well as fixed period costs such as rent or salaries.

Question 4

What is the purpose of the CVP model?

Answer 4

The purpose of the CVP model is to predict how income is affected by changes in costs, and changes in sales level.

Question 5

What are the six key assumptions in the basic CVP Model?

Answer 5

1) The number of output units is the only revenue driver and cost driver. By extension, we assume that other influences such as marketing campaigns, the economy, and customer mix are not considered.
2) Total costs can be divided into variable costs and fixed costs.
3) Total revenue and total costs are linear within the relevant range. This assumes that costs and revenues increase at a constant rate with output. That means there are no economies of scale, or volume discounts–everything behaves in a straight line within the relevant range.
4) Unit selling price, unit variable costs, and fixed costs are known and constant.
5) Single product or constant sales mix. The model assumes that either only one product is sold, or there’s a consistent sales mix of products.
6) Time value of money effect is ignored.

Question 6

When does the break even point occur?

Answer 6

The break even point occurs when total contribution margin equals total fixed costs.

Question 7

How do we find break-even units by using the per-unit approach?

Answer 7

-Taking the per-unit approach, we find that break-even units=Fixed Costs/CM per unit.

Question 8

How do we find the break-even sales using the contribution margin ratio?

Answer 8

-Taking the contribution margin ratio, we find that break-even sales=fixed costs/CM Ratio.

Question 9

How do we find the required units or required sales when the fixed amount of profit is before tax? How does that change when the fixed amount of profit is after tax?

Answer 9

-If profit target is before tax (EBT), then required units=(FC+EBT)/CM per unit. This will align with the per-unit approach.
-Or with the required sales=(FC+EBT)/CM Ratio This will align with the ratio approach.
-If profit target is after tax, then EBT=EAT/1-Tax rate (Tx).
-In that case, required units=(FC+(EAT/1-Tx))/CM per unit. This would align with the per-unit approach.
-Or to get required sales, sales=(FC+(EAT/1-TX))/CM Ratio.
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Question 10

How do you find the desired profit as a percentage of sales? How does this change if we are looking for this number before tax vs after tax?

Answer 10

-Looking for desired profit as a percentage of sales before taxes, the equation is Sales-x%S-y%S=Fixed Costs… where S=Sales, x%S=variable costs, and y%S=desired profit. We must solve for x to find the solution.
-Looking for desired profit as a percentage of sales after taxes, y%s=z%s/1-Tax Rate.
-That gives you the same formula which is S-x%S-y%S=FC, which is the same form but luckily it accounts for taxes.

Question 11

What is degree of operating leverage?

Answer 11

-Degree of operating leverage measures how a change in sales will affect operating income.
-DOL=Contribution Margin/EBT.
-That means that the higher the fixed costs, the higher the contribution margin, and by extension the operating leverage will be higher as well.
-A company with high operating leverage may experience a small change in sales which leads to large changes in operating income.
-A higher operating leverage means that there will be a higher risk, and by extension a higher reward as well.