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Chapter 3

ACC 410 Chapter Notes - Chapter 3: Contribution Margin, Variable Cost, Operating Leverage

Course Code
ACC 410
Maurizio Di Maio

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Chapter 3
Chapter Overview
Cost–volume-profit (CVP) analysis helps managers
understand the interrelationships among cost, volume, and profit by focusing their attention
on the interactions among the process of products, volume of activity, per unit variable
costs, total fixed costs, and mix of products sold.
choose the most favourable combination of variable costs, fixed costs, selling price, sales
volume, and mix of products sold.
Various concepts will be covered such as the unit contribution margin, the break-even point,
the CM ratio, margin of safety, operating leverage, and the sales mix.
A.The Basics of Cost-Volume-Profit (CVP) Analysis. Cost-volume-profit (CVP)
analysis is a key step in many decisions. CVP analysis involves specifying a model of the
relations among the prices of products, the volume or level of activity, the unit variable costs, the
total fixed costs, and the mix of products sold. This model is used to predict the impact on profits
of changes in those parameters.
1. Contribution Margin. Contribution margin is the amount remaining from sales revenue
after variable expenses have been deducted. It contributes towards covering fixed costs and
then towards profit.
2. Unit Contribution Margin. When there is a single product, the unit contribution margin
can be used to predict changes in the contribution margin and in profits (assuming there is
no change in fixed costs) as a result of changes in unit sales. To do this, the unit
contribution margin is simply multiplied by the change in unit sales.
3.Contribution Margin Ratio. The contribution margin (CM) ratio is the ratio of the
contribution margin to total sales. It shows how the contribution margin is affected by a
given dollar change in total sales. Managers often find the contribution margin ratio
easier to work with than the unit contribution margin, particularly when a company has
multiple products. This is because the contribution margin ratio is denominated in sales
dollars, which is a convenient way to express activity in multi-product firms.
B. Some Applications of CVP Concepts. CVP analysis is typically used to estimate the
impact on profits of changes in selling price, variable cost per unit, sales volume, and total fixed
costs. CVP analysis can be used to estimate the effect on profits of a change in any one (or any
combination) of these parameters. A variety of examples of applications of CVP are provided in
the text.
C.CVP Relationships in Graphic Form. Graphs of CVP relationships can be used to
gain insight into the behaviour of expenses and profits. The basic CVP graph is drawn with
dollars on the vertical axis and volume in units on the horizontal axis. Total fixed expense is
drawn first, then variable expense is added to the fixed expense in order to draw the total
expense line. Finally, the total revenue line is drawn. The total profit (or loss) is the vertical
difference between the total revenue and total expense lines.
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D.Break-Even Analysis and Target Profit Analysis. Target profit analysis is concerned
with estimating the level of sales required to attain a specified target profit. Break-even analysis
is a special case of target profit analysis in which the target profit is zero.
1. Basic CVP equations. Both the equation and contribution (formula) methods of break-
even and target profit analysis are based on the contribution approach to the income
statement. The format of this statement can be expressed in equation form as:
Profits = Sales Variable expenses Fixed expenses
In CVP analysis this equation is commonly rearranged and expressed as:
Sales = Variable expenses + Fixed expenses + Profits
a.The above equation can be expressed in terms of unit sales:
Price × Unit sales = Unit variable cost × Unit sales + Fixed expenses + Profits
Unit contribution margin × Unit sales = Fixed expenses + Profits
Unit sales =
marginon contributiUnit
Profits+ expenses Fixed
b. The basic equation can also be expressed in terms of sales dollars using the variable
expense ratio:
Sales = Variable expense ratio × Sales + Fixed expenses + Profits
(1 Variable expense ratio) × Sales = Fixed expenses + Profits
Contribution margin ratio* × Sales = Fixed expenses + Profits
Sales =
ratiomargin on Contributi
Profits+ expenses Fixed
* 1 Variable expense ratio= 1
expenses Variable
expenses Variable-Sales
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