Chapter3D CVP ANALYSIS AND OPERATING LEVERAGE. BSNL, India For Internal Circulation Only 1


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1 Chapter3D CVP ANALYSIS AND OPERATING LEVERAGE BSNL, India For Internal Circulation Only 1
2 CVP ANALYSIS AND OPERATING LEVERAGE Introduction: Cost Volume Profit analysis is a study of the interrelationship between the following factors: 1. Prices of Products. 2. Volume or level of activity. 3. Per Unit variable costs. 4. Total fixed costs. 5. Mix of products sold. CVP analysis helps the Management to take decisions like choice of product lines, pricing of products, marketing strategy, and utilization of productive facilities. The concept of CVP Analysis is so pervasive in Managerial Accounting that it touches on virtually everything that a manager does. Because of its wide range of usefulness, CVP analysis is undoubtedly the best tool the manager has for discovering the untapped profit potential that may exist in an organization. The Basics of CostVolumeProfit Analysis: We should understand the term Contribution Margin before further study of CVP Analysis. Contribution Margin is the amount available after deducting the variable expenses from Sales figure. It is worked out for Total Sales as well as Sales per Unit. Let s try to understand this with the help of the following example. BSNL, India For Internal Circulation Only 2
3 X Company. Contribution Income Statement For the month of. Total Per Unit Sales (400 Ovens) $ $ 250 Less variable expenses Contribution Margin $ 100 Less fixed expenses Net Income $ 5000 Note : X Company is a manufacturer of Ovens and for the purpose of discussions let s assume that it produces only one model of oven. Notice that the company expresses its sales, variable expenses and contribution margin on a per unit basis as well as in total. This is commonly done on those income statements prepared for management s use internally since, as we shall see, it facilitates profitability analysis. Therefore, Contribution Margin is the amount remaining from sales revenue after variable expenses have been deducted that can be used to contribute toward the covering of fixed expenses and then toward profits for the period. Notice the sequence herecontribution margin is used first to cover the fixed expenses, and then whatever remains after the fixed expenses are covered goes towards profits. If the contribution margin is not sufficient to cover the fixed expenses, then a loss occurs for the period. In addition to being expressed on a per unit basis, revenues, variable expenses, and contribution margin for an organization can also be expressed on a percentage basis : BSNL, India For Internal Circulation Only 3
4 X Company. Contribution Income Statement For the month of. Total Per Unit Percent Sales (400 Ovens) $ $ Less variable expenses Contribution Margin $ Less fixed expenses Net Income $ 5000 The percentage of contribution margin to total sales is referred to either as the contribution margin ration (CM ratio) or as the profitvolume ratio (P/V ratio). This ratio is extremely useful in that it shows how the contribution margin will be affected by a given dollar change in total sales. To illustrate, notice that the X Company has a CM ratio of 40%. This means that for each dollar increase in sales, total contribution margin will increase by 40 cents, assuming that there are no changes in fixed costs. As this illustration suggests, the impact on net income of any given dollar change in total sales can be computed in seconds by simply applying the CM ratio to the dollar change. If the X Company plans a $ 30,000 increase in sales during the coming month, for example, management can expect contribution margin to increase by $ 12,000 ($ increased sales * CM ratio of 40 percent). As we noted above, the net income will increase by a like amount if the fixed costs do not change. As proof: Sales Volume Present Expected Increase Percent Sales $ $ $ Less variable Expenses * Contribution Margin Less fixed expenses Net Income $ 5000 $ $ $ * 60% = $ BSNL, India For Internal Circulation Only 4
5 Many managers find the CM ratio easier to work with than the unit contribution margin figure, particularly where a company has multiple product lines. This is because an item in ratio form facilitates comparisons between products. Other things being equal, the manager will search out those product lines that have the highest CM ratios. The reason, of course, is that for a given dollar increases in sales these product lines will yield the greatest amount of contribution margin toward the covering of fixed costs and toward profits. Operating Leverage: Operating leverage is a measure of the extent to which fixed costs are being used in an organization. It is greatest in companies that have a high proportion of fixed costs in relation to variable costs. Conversely, operating leverage is lowest in companies that have a low proportion of fixed costs in relation to variable costs. If a company has high operating leverage (that is, a high proportion of fixed costs in relation to variable costs), then profits will be very sensitive to changes in sales. Just a small percentage increase (or decrease) in sales can yield a large percentage increase (or decrease) in profits. The degree of operating leverage existing in a company at a given level of sales can be measured by the following formula: Contribution margin = Degree of Operating Leverage. Net Income The degree of operating leverage is a measure, at a given level of sales, of how a percentage change in sales volume will affect profits. To illustrate, the degree of operating leverage existing in Company A and B at a $ sales level would be: Company A: $ 40000/$10000 = 4 Company B: $ 70000/$10000 = 7 BSNL, India For Internal Circulation Only 5
6 Thus by interpretation, these figures tell us that for a given percentage change in sales we can expect a change four times as great in the net income of Company A and change seven times as great in the net income of Company B. The operating leverage concept provides the manager with a tool that can signify quickly what impact various percentage changes in sales will have on profits, without the necessity of preparing detailed income statements. As shown by examples, the effects of operating leverage can be dramatic. If a company is fairly near its break even point, then even small increases in sales can yield large increases in profits. This explains why management will often work very hard for only a nominal increase in sales volume. If the degree of operating leverage is 5, then a 6 percent increase in sales would translate into a 30 % increase in profits. Questions: 1. What are the factors used for CVP analysis? 2. What is Cost Volume Profit Analysis? Discuss. 3. Write a short Note on Contribution Margin. 4. What do you understand by Operating Leverage? Discuss BSNL, India For Internal Circulation Only 6
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