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1 Gross C.M.

= Sales - Variable COGM


2 Net C.M. = Sales - Variable COGM - Variable operating expenses
Net C. M. = Gross C.M. - Variable operating expenses

Example No.1:
Total Per unit

Sale (400 Speakers) 100,000 250


Less: Variable Cost (60,000) (150)

Contribution Margin 40,000 100


Less: Fixed Cost (35,000)
Net Operating Income 5,000

Explaination of change in activity affect Contribution Margin & Net Operating Income:

On Sale of 1 Speaker:
Total Per unit

Sale (1 Speaker) 250 250


Less: Variable Cost (150) (150)

Contribution Margin 100 100


Less: Fixed Cost (35,000)

Net Operating Loss (34,900)


On Sale of 2 Speakers:
Total Per unit

Sale (2 Speakers) 500 250


Less: Variable Cost (300) (150)

Contribution Margin 200 100


Less: Fixed Cost (35,000)

Net Operating Loss (34,800)

On Sale of 350 Speakers:


Total Per unit

Sale (350 Speakers) 87,500 250


Less: Variable Cost (52,500) (150)

Contribution Margin 35,000 100


Less: Fixed Cost (35,000)

Net Operating Income -

On Sale of 351 Speakers:


Total Per unit

Sale (351 Speakers) 87,750 250


Less: Variable Cost (52,650) (150)

Contribution Margin 35,100 100


Less: Fixed Cost (35,000)

Net Operating Income 100

Increased in numbers of speakers sold 25


Contribution margin per speaker x $ 100
Increase in Net Operating Income 2,500

CONTRIBUTION MARGIN RATIO:


C. M. Ratio = TotalContribution Margin 40,000
Total Sales 100,000

Or: C. M. Ratio = Contribution Margin Per unit 100


Sales price Per unit 250

Impact on Net Operating Income on changes in Sales, by C.M. ratio:


Calculation of changes in net income, with the changes in sales, without I/S
Increase in Sales 30,000
C.M. ratio 40%

Increase in Net operating Income 12,000

Decrease in Sales 40,000

C.M. ratio 40%

Decrease in Net operating Income 16,000

There is a direct relationship or proportion between sales and contribution margin


as well as net income

Proof: Present Expected Changes Percentage

Sales 100,000 130,000 30,000 100%


Less: Variable Cost (60,000) (78,000) (18,000) 60%

Contribution Margin 40,000 52,000 12,000 40%

Less: Fixed Cost (35,000) (35,000) -

Net Operating Income 5,000 17,000 12,000

Some Applications of CVP Analysis:


Consider the following example:

Selling Price per unit 250


Variable Cost per unit 150
C. M. (in amount) 100
C.M. Ratio 40%
Fixed Cost 35,000 per month.
Current Sales (in units) 400

Concept No.1: (Change in Fixed Cost and Sales Volume):

Sales manager feels that by increase in $10,000 fixed cost i.e, advertising budget,
then the sale will increase by $30,000 to a total 520 units. Should the advertising
budget increase,

Expected total contribution margin


($130,000 x 40%) 52,000

Present total contribution margin


($100,000 x 40%) 40,000

Increase in Contribution Margin 12,000


Increase in fixed cost 10,000
Increase in Net Operating Income 2,000

OR
Increase in sales 30,000
Contribution Margin ratio 40%

Increase in Contribution Margin 12,000


Increase in fixed cost 10,000
Increase in Net Operating Income 2,000

OR

Proof: Present Expected Changes Percentage

Sales 100,000 130,000 30,000 100%


Less: Variable Cost (60,000) (78,000) (18,000) 60%

Contribution Margin 40,000 52,000 12,000 40%


Less: Fixed Cost (35,000) (45,000) (10,000)

Net Operating Income 5,000 7,000 2,000

Concept No.2: (Change in Variable Cost and Sales Volume):


Assumption:
Management consider to change the part with more high quality part.
This will increase the variable cost by $10 which decrease the
contribution margin by $ 10. It increases the sales to 480 speakers.
Should this changes incorporated:

Expected total contribution margin


(480 Speakers x $ 90) 43,200

Present total contribution margin


(400 speakers x $100) 40,000

Increase in Contribution Margin 3,200

OR

Proof: Present Expected Changes

Sales 100,000 120,000 20,000


Less: Variable Cost (60,000) (76,800) (16,800)
Contribution Margin 40,000 43,200 3,200

Less: Fixed Cost (35,000) (35,000)

Net Operating Income 5,000 8,200 3,200

Concept No.3: (Change in Fixed Cost, Sales Price and Sales Volume):

Assumption:
Management consider to cut the selling price by $20 per speaker,
increases fixed cost by $15,000 in advertising budget per month,
these changes increases the sales by 50% i.e. 600 speakers.
Should this changes incorporated:

Expected total contribution margin


(600 speakers x $80) 48,000

Present total contribution margin


(400 speakers x $ 100) 40,000

Increase in Contribution Margin 8,000


Increase in fixed cost 15,000
Decrease in Net Operating Income (7,000)

OR
Proof: Present Expected

Sales 100,000 250 138,000 230


Less: Variable Cost (60,000) (150) (90,000) (150)

Contribution Margin 40,000 100 48,000 80

Less: Fixed Cost (35,000) (50,000)


Net Operating Income 5,000 (2,000)

Concept No.4: (Change in Variable Cost, Fixed Cost and Sales Volume):

Assumption:
Management decided to pay $15 per speaker commission to
Sales person and stop payment of $6,000 fixed amount of
salaries, this change will increase the monthly sales by 15%
i.e. to 400 speakers to 460 speakers per month.
Should this changes incorporated:

Expected total contribution margin


(460 speakers x $85) 39,100

Present total contribution margin


(400 speakers x $100) 40,000

Decrease in Contribution Margin (900)


Decrease in fixed cost 6,000
Increase in Net Operating Income 5,100

OR

Proof: Present Expected

Sales 100,000 250 115,000 250


Less: Variable Cost (60,000) (150) (75,900) (165)

Contribution Margin 40,000 100 39,100 85


Less: Fixed Cost (35,000) (29,000)

Net Operating Income 5,000 10,100


perating Income:
40%

40%

ution margin

ercentage
ercentage
Changes

38,000
(30,000)

8,000

(15,000)
(7,000)

Changes

15,000
(15,900)

(900)
6,000

5,100
Break even Analysis:

### Computation of Break even analysis by Equation method:

Break even point (in amount)

Sale = Variable cost + Fixed Cost + Desired Profit

### Computation of Break even analysis by Formula:

Break even point (in amount) = Fixed Cost


C.M. Ratio

Break even point (in units) = Fixed Cost


C.M. per unit

Target Profit Analysis:


It is also done by break even analysis (equation method)

Margin of Safety:
Margin of safety is the excess of budgeted (or actual) sales over the break even sales.
BEP provided the line below which company suffered loss. Higher the margin of safety, the
lower the risk of not breaking even.

a) Margin of Safety = Total Sales (actual) - Break even sales

b) Margin of Safety (in Percentage) = Margin of Safety (in amount)


Total budeted (or actual) sales

c) In a single product firm, the margin of safety can also be expressed in terms of
number of units.
Margin of Safety (in units) = Margin of Safety (in amount)
Sales price per unit
Or
Margin of Safety (in units) = Actual units sold - BEP (in units)

Example:
### MOS = $100,000 - $87,500 $ 12,500
### MOS (%) = $ 12,500 12.5%
$100,000

### MOS (in units) = $ 12,500 50 units


$250

MOS (in units) = 400 speakers - 350 speakers

MOS (in units) = 50 units

Operating Leverage:
It is a measure of how sensitive net operating income is to percentage changes in sales.
It means that if operating leverage is high then the small percentage change can produce
large increasein net income and vice versa.

Example: Farm A Farm B


Sales 100,000 100,000
Less: Variable cost (60,000) (30,000)

Contribution Margin 40,000 70,000


Less: Fixed Cost (30,000) (60,000)
Net Operating Income 10,000 10,000

Degree of operating leverage = Contribution Margin


Net operating Income

DOL (A)= 40,000 4 times


10,000

DOL (B)= 70,000 7 times


10,000
Consider the impact of change of 10% increase in sales of two companies

Farm A Farm B
10%
Sales 100,000 110,000 100,000
Less: Variable cost (60,000) (66,000) (30,000)

Contribution Margin 40,000 44,000 70,000


Less: Fixed Cost (30,000) (30,000) (60,000)
Net Operating Income 10,000 14,000 10,000

Change in Net Operating Income (in amount) 4,000

Change in Net Operating Income (in times) 4,000


10,000

Changes in Percentage 40

Consider the impact of change of 12% decrease in sales of two companies

Farm A Farm B
12%
Sales 100,000 88,000 100,000
Less: Variable cost (60,000) (52,800) (30,000)

Contribution Margin 40,000 35,200 70,000


Less: Fixed Cost (30,000) (30,000) (60,000)
Net Operating Income 10,000 5,200 10,000

Change in Net Operating Income (in amount) (4,800)

Change in Net Operating Income (in times) (4,800)


10,000

Changes in Percentage (48)


of safety, the
es in sales.
an produce
Farm B
10%
110,000
(33,000)

77,000
(60,000)
17,000

7,000

7,000
10,000

70

Farm B
12%
88,000
(26,400)

61,600
(60,000)
1,600

(8,400)

(8,400)
10,000

(84)
Review Problem
Total Per unit Percentage
of Sales
Sales 1,200,000 60 100%
Less: Variable cost (900,000) (45)

Contribution Margin 300,000 15


Less: Fixed Cost (240,000)
Net Operating Income 60,000

Required:
1 Compute Company's C. M ratio and Variable expense ratio.

2 Compute the company's break even point (in units) and (in dollars), by equation method.

3 Assume that sales increase by $400,000 next year. If cost behaviour pattern remain constant,
by how much will the company net operating income increase? Use the C.M. ratio to
determine your answer.

4 Refer to the original data. Assume that next year management wants the company
earn a min. profit of $ 90,000. How much units will have to be sold to meet
this target profit figure?

5 Refer, to the original data, Compute the company's margin of safety (in dollar)
and (in percentage)

6
a Compute the company degree of operating leverage at the present level of sale

b Assume that through a more intense effort by the sales staff the company sale increase
by 8% next year. By what percentage would you expect ner operating income increases?
Use the operating leverage concept.

c Verify your answer through Income Statement.

7 In an effort to increase the sales and profit, management is considering the use of
a higher quality speaker. The higher quality speaker would increase the variable cost
by $3 per unit, but management could eliminate one quality inspector who is paid a
salary of #30,000 per year. The sales manager estimate that the higher quality speaker
would increase annual sales by atleast 20%.

a) Assuming that chanes are made as described above, prepare projected


income statement for next year. Show a data on a total, per unit and percentage basis.

b) Compute the company's new breakeven point in both units and dollar of sales.
Use C.M method.

c) Would you recommend that the change be made?


equation method.

attern remain constant,


C.M. ratio to

he company

ny sale increase
ncome increases?

the use of
e variable cost
ho is paid a
quality speaker
rcentage basis.

r of sales.
Req (I) ContributionMargin Ratio and Variable cost ratio:

CONTRIBUTION MARGIN RATIO:

C. M. Ratio = TotalContribution Margin


Total Sales

Or: C. M. Ratio = Contribution Margin Per unit


Sales price Per unit

VARIABLE COST RATIO:

Variable Cost ratio = Variable Cost


Sales

Req (II) Computation of Break even analysis by Equation method:

Break even point (in amount)

Sale = Variable cost + Fixed Cost + Desired Profit


X = 0.75X +240,000 + 0
0.25 X = 240,000
X = 240,000 / 0.25
X = Sales = 960,000

Break even point (in units)

= Amount of BEP (in Amount)


Sales price per unit

Req (III) Impact on Net Operating Income on changes in Sales, by C.M. ratio:

Calculation of changes in net income, with the changes in sales, without I/S
Increase in Sales 400,000
C.M. ratio 25%

Increase in Net operating Income


Req (IV) Target Profit of $ 90,000

Sale = Variable cost + Fixed Cost + Desired Profit


X = 0.75X +240,000 + 90,000
0.25 X = 330,000
X = 330,000 / 0.25
X = Sales = 1,320,000

Nos. of units to be sold to earn $ 90,000:

= Amount of Sales
Sales price per unit

Req (V) Margin of Safety (in amount) and (in percentage)

a) Margin of Safety = Total Sales (actual) - Break even sales

Margin of Safety = 1,200,000 - 960,000

Margin of Safety = 240,000

b) Margin of Safety (in Percentage) = Margin of Safety (in amount)


Total budeted (or actual) sales

Margin of Safety (in Percentage) = 240,000 20


1,200,000

Req (VI)
a) Degree of Operating Leverage

Degree of operating leverage = Contribution Margin


Net operating Income

DOL = 300,000
60,000

DOL = 5 times.

b) Impact on Net Income, When Sales increases 8% by the help of DOL


Increase in Sales 8%

DOL = 5 times

Increase in Net Operating Income = 8% x 5 times

Increase in Net Operating Income = 40%

c) Verify the answer by Income Statement:


Increase by
8%
Sales 1,200,000 1,296,000
Less: Variable cost (900,000) (972,000)

Contribution Margin 300,000 324,000


Less: Fixed Cost (240,000) (240,000)
Net Operating Income 60,000 84,000

Change in Net Operating Income (in amount) 24,000

Change in Net Operating Income (in times) 24,000


60,000

Changes in Percentage 40

Req (VII)
a) Changes in Variable Cost, Sales and Fixed Cost:

Present Rate Expected


Sales 1,200,000 60 1,440,000
Less: Variable cost (900,000) (45) (1,152,000)

Contribution Margin 300,000 15 288,000


Less: Fixed Cost (240,000) (210,000)
Net Operating Income 60,000 78,000

b) Break even Sales (in amount) and (in units) by CM Ratio:

Computation of Break even analysis by Formula:


Break even point (in amount) = Fixed Cost 210,000
C.M. Ratio 20%

Break even point (in units) = Fixed Cost 210,000


C.M. per unit 12

c) Yes, the proposed changes will incorporate because from these changes company
earn $18,000 more than Present level.
300,000 25
1,200,000

15 25
60

900,000 75
1,200,000

960,000 16,000 units


60

s, by C.M. ratio:

ales, without I/S

100,000
1,320,000 22,000 units
60

tual) sales

help of DOL
Rate Percent
60 100
(48) (80)

12 20
1,050,000

17,500

changes company