Effect of Change in Fixed Cost and Sales Volume on Contribution Margin
and Profitability:
Learning Objectives:
- What is the effect of change in fixed
costs and sales volume on contribution margin and profitability?
The following data is used to show
how changes in
fixed costs and sales volume can effect company's
contribution
margin and profitability.
Basic Data:
Selling price: $250 (100%)
Variable Expenses: $150 (60%)
Contribution Margin: $250 – $150 = $100 (40%)
Fixed Expenses: $35,000 per month
Suppose that a company is currently selling 400 units per month
(monthly sales of $100,000).The sales
manager feels that a $10,000 increase in
the advertising budget would increase monthly sales by $30,000 to a total of 520
units. Should the advertising budget be increased? The following table shows the
effect of the proposed change in the monthly advertising budget.
|
Current Sales |
Sales with additional advertising budget |
Difference |
Percent of sales |
| Sales |
$100,000 |
$130,000 |
$30,000 |
100% |
| Less variable expenses |
$60,000 |
$78,000 |
$18,000 |
60% |
| |
--------- |
--------- |
--------- |
--------- |
| Contribution margin |
40,000 |
52,000 |
12,000 |
40% |
| Less fixed expenses |
35,000 |
45,000 |
10,000 |
====== |
| |
--------- |
--------- |
--------- |
|
| Net operating income |
$5,000 |
$7,000 |
$2,000 |
|
| |
====== |
====== |
====== |
|
|
Assuming no other factors need to be
considered, the increase in the advertising budget should be approved since it
would lead to an increase in
net operating income of $2,000. There are two
shorter ways to present this solution. The first alternate solution follows:
Alternative Solution 1:
| Expected total contribution margin: |
|
| $130,000 × 40% CM ratio |
$52,000 |
| Present total contribution margin: |
|
| $100,000 × 40% CM ratio |
40,000 |
| |
--------- |
| Incremental contribution margin |
12,000 |
| Less incremental advertising expenses |
10,000 |
| |
--------- |
| Increased net operating income |
$2,000 |
| |
======= |
|
Since in this case the fixed costs
and the sales volume change, the solution can be presented in an even shorter
format.
Alternative Solution 2:
|
Incremental contribution margin: |
|
| $30,000 × 40%
Contribution Margin ratio |
$12,000 |
| Less incremental advertising expenses |
10,000 |
|
--------- |
| Increased net operating income |
$2,000 |
|
Notice that this approach does not
depend on knowing of previous sales. Also notice that it is unnecessary under
either shorter approach to prepare an
income statement. Both of the solutions
above involve an
incremental analysis. They consider only those items of
revenue, cost, and volume that will change if the new program is implemented.
Although in each case a new
income statement could have been prepared, the
incremental approach is simpler and more direct and focuses attention on the
specific items involved in the decision.
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