Accounting: The Language of Business - Vol. 1 (Part 121)

"When it`s all over but the shoutin` / When God the Father`s done his final accounting / And I find out that I made the cut / Boys I`m gonna get me a chariot." - John Caldwell 

 Cost Behavior and Cost-Volume-Profit Analysis (Part C)

by

Charles Lamson

Cost-Volume-Profit Relationships

After costs have been classified as fixed and variable, their effect on revenues, volume, and profits can be studied by using cost volume profit analysis. Cost-volume-profit analysis is the systematic examination of the relationships among selling prices, sales and production volume, costs, expenses, and profits.

Cost volume profit analysis provides management with useful information for decision making. For example, cost-volume-profit analysis may be used in setting selling prices, selecting the mix of products to sell, choose among marketing strategies, and analyzing the effects of changes in costs on profits. In today's business environment, management must make such decisions quickly and accurately. As a result, the importance of cost volume profit analysis has increased in recent years.

Contribution Margin Concept

One relationship among cost, volume, and profit is the contribution margin. The contribution margin is the excess of sales revenues over variable costs. The contribution margin concept is especially useful in business planning because it gives insight into the profit potential of a firm. To illustrate, the income statement of Lambert Inc. in Exhibit 4 has been prepared in a contribution margin format.

EXHIBIT 4 Contribution Margin Income Statement

The contribution margin of $400,000 is available to cover the fixed costs of $300,000. Once the fixed costs are covered, any remaining amount adds directly to the income from operations of the company. Consider the graphic below. The fixed costs are a bucket and the contribution margin is water filling the bucket. Once the bucket is filled, the overflow represents income from operations. Up until the point of overflow, however, the contribution margin contributes to fixed costs (filling the bucket).

Contribution Margin Ratio

The contribution margin can also be expressed as a percentage. The contribution margin ratio, sometimes called the profit volume ratio, indicates the percentage of each sales dollar available to cover the fixed costs and to provide income from operations. For Lambert Inc., the contribution margin ratio is 40%, as computed below.

Contribution margin ratio = Sales - Variable costs / Sales

Contribution margin ratio = $1,000,000 - $600,000 / $1,000,000 = 40%

The contribution margin ratio measures the effect of an increase or a decrease in sales volume on income from operations. For example, assume that the management of Lambert Inc. is studying the effect of adding $80,000 in sales orders. Multiplying the contribution margin ratio (40%) by the change in the sales volume ($80,000) indicates that income from operations will increase $32,000 if the additional orders are obtained. The validity of this analysis is illustrated by the following contribution margin income statement of Lambert Inc.:

 Variable costs as a percentage of sales are equal to 100% minus the contribution margin ratio. Thus, in the above income statement, the variable costs are 60% (100% - 40%) of sales, or $648,000 ($1,800,000 * 60%). The total contribution margin, $432,000, can also be computed directly by multiplying the sales by the contribution margin ratio ($1,080,000 * 40%).

In using the contribution margin ratio in analysis, factors other than sales volume, such as variable cost per unit and sales price, are assumed to remain constant. If such factors change, their effect must be considered.

The contribution margin ratio is also useful in setting business policy. For example, if the contribution margin ratio of a firm is large and production is at a level below 100% capacity, a large increase in income from operations can be expected from an increase in sales volume. A firm in such a position might decide to devote more effort to sales promotion because of the large change in income from operations that will result from changes in sales volume. In contrast, a firm with a small contribution margin ratio will probably want to give more attention to reducing costs before attempting to promote sales.

Unit Contribution Margin

The unit contribution margin is also useful for analyzing the profit potential of proposed projects. The unit contribution margin is the sales price less the variable cost per unit. For example, if Lambert Inc.'s unit selling price is $20 and its unit variable cost is $12, the unit contribution margin is $8 ($20 - $12).

The contribution margin ratio is most useful when the increase or decrease in sales volume is measured in sales dollars. The unit contribution margin is most useful when the increase or decrease in sales volume is measured in sales units (quantities). To illustrate, assume that Lambert Inc. sold 50,000 units. Its income from operations is $100,000, as shown in the following contribution margin income statement:

If Lambert Inc.'s sales could be increased by 15,000 units, from 50,000 units to 65,000 units, its income from operations would increase by $120,000 (15,000 units * $8), as shown below.

Unit contribution margin analyses can provide useful information for managers. The preceding illustration indicates, for example, that Lambert could spend up to $120,000 for special advertising or other product promotions to increase sales by 15,000 units. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 831-833*

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