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Managerial Accounting Cost Volume Profit Analysis CVP. Calculation of Break Even Analysis, Break even chart, and Contribution Margin Ratio (CM Ratio)
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Break Even Analysis, and Contribution Margin Ratio (CM Ratio)
Cost volume profit analysis is the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost volume and profit in an organization by focusing on interactions among the following five elements:
1)Prices of products
2)Volume or level of activity
3)Per unit variable cost
4)Total fixed cost
5)Mix of product sold
Because CVP analysis helps managers understand the interrelationships
among cost, volume, and profit it is a vital tool in many business decisions. These decisions include, for example, what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire.
Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. Thus it is the amount available to cover fixed expenses and then to provide profits for the period. Contribution margin is first used to cover the fixed expenses and then whatever remains go toward profits. If the contribution margin is not sufficient to cover the fixed expenses, then a loss occurs for the period.
Example:
Consider the following income statement of Masers A.Q. Asem Private Ltd.
|
Total |
Per unit |
| Sales (1 Unit only) Less Variable expenses Contribution margin Net operating loss |
$ 250 |
$250 |
Assume that company has been able to sell only one unit of product during the period. If company does not sell any more units the income statement will appear as above. For each additional unit that the company is able to sell during the period, $100 more in contribution margin will become available to help cover the fixed expenses. if a second unit is sold, for example, then the total contribution margin will increase by $100 (to a total of $200) and the company's loss dill decrease by $100, to $34800. If enough units can be sold to generate $35000 in contribution margin, then all of the fixed costs will be covered and the company will have managed to at least break even for the month-that is to show neither profit nor loss but just cover all of its costs. To reach the break even point, the company will have to sell 350 units in a period, since each unit sold contribute $100 in the contribution margin.
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Total |
Per Unit |
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| Sales (350 Units) Less Variable expenses Contribution margin Net operating loss
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$87,500 |
$250 |
Note that the break even is the level of sales at which profit is zero.
Once the break even has been reached, net income will increase by unit contribution margin by each additional unit sold. For example, if 351 units are sold during the period then we can expect that the net income for the month will be $100, since the company will have sold 1 unit more than the number needed to break even
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Total |
Per Unit |
|
| Sales (351 Units) Less Variable expenses Contribution margin Net operating loss |
$87,750 |
$250 |
If 352 units are sold then we can expect that net operating income for the period will be $200 and so forth. To know what the profit will be at various level of activity, therefore, manager do not need to prepare a whole series of income statements. To estimate the profit at any point above the break even point, the manager can simply take the number of units to be sold above the breakeven and multiply that number by the unit contribution margin. The result represents the anticipated profit for the period. Or to estimate the effect of a planned increase in sale on profits, the manager can simply multiply the increase in units sold by the unit contribution margin. The result will be expressed increase in profits. To illustrate it suppose company is currently selling 400 units and plans to sell 425 units in near future, the anticipated impact on profits can be computed as follows.
| Increased number of units to be sold Contribution margin per unit Increase in the operating income |
25 |
To summarize these examples, if there were no sales, the company's loss would equal to its fixed expenses. Each unit that is sold reduces the loss by the amount of the unit contribution margin. Once the break even point has been reached, each additional unit sold increases the company's profit by the amount of the unit contribution margin
The anticipated profit or loss at any given level of sales is measured by the vertical distance between the total revenue line (Sales) and the total expenses line (variable expenses plus fixed expenses) The break even point is where the total revenue and total expenses lines cross. The break even point of 350 units agrees with the break even point computed earlier. As discussed earlier when sales are below the break even point-in this case, 350 units-the company suffers a loss. Note that the loss (represented by the vertical distance between the total expense and total revenue lines) gets worse as the sales decline. When sales are above the break even point, the company earns a profit and the size of the profit represented y the vertical distance between the total revenue and total expense lines) increase as sales increase.
The contribution margin as a percentage of total sales is referred to as contribution margin ratio (CM Ratio)
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CM Ratio = Contribution Margin / Sales |
Contribution margin ratio can be used in cost-volume profit calculations. Consider the following Income statement of A. Q. Asem private Ltd.
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Total |
Per Unit |
Percent of Sales |
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| Sales (400 units) Less Variable expenses Contribution margin Net operating loss
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$100,000 |
$250 |
100% |
For A. Q. Asem private Ltd. CM Ratio = Contribution Margin / Sales = $40,000 / $100,000 = 40%
In a company that has only one product such as A.Q. Asem CM ratio can also be calculated as follows
CM Ratio = Unit contribution margin / Unit selling price $100/$250 = 40%
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