Cost Behavior and Cost-Volume-Profit Analysis LO 2 – Understanding the Contribution Margin Concept

Cost-Volume-Profit Relationships LO 2 Cost-Volume-Profit Relationships Cost-volume-profit analysis is the examination of the relationships among selling prices, sales and production volume, costs, expenses, and profits. Cost-volume-profit analysis is an integral part of financial planning and decision making. Cost-volume-profit analysis is the examination of the relationships among selling prices, sales and production volume, costs, expenses, and profits.

Cost-Volume-Profit Relationships LO 2 Cost-Volume-Profit Relationships Some of the ways cost-volume-profit analysis may be used include the following: Analyzing the effects of changes in selling prices on profits Analyzing the effects of changes in costs on profits Some of the ways cost-volume-profit analysis may be used include the following: Analyzing the effects of changes in selling prices on profits Analyzing the effects of changes in costs on profits (continued)

Cost-Volume-Profit Relationships LO 2 Cost-Volume-Profit Relationships Analyzing the effects of changes in volume on profits Setting selling prices Selecting the mix of products to sell Choosing among marketing strategies Continued from the previous slide: Analyzing the effects of changes in volume on profits 4. Setting selling price Selecting the mix of products to sell Choosing among marketing strategies

LO 2 Contribution Margin Contribution margin is the excess of sales over variable costs, as shown in the formula below. Contribution Margin = Sales – Variable Costs The contribution margin can be useful for analyzing the profit potential of projects. The contribution margin is the sales less the variable costs.

Contribution Margin Assume the following data for Lambert, Inc.: LO 2 This slide shows data for Lambert, Inc.

Contribution Margin Contribution Margin LO 2 The contribution margin income statement reports the total contribution margin of $400,000 by subtracting variable costs of $600,000 from sales of $1,000,000. After variable costs are deducted from sales, the contribution margin will cover the fixed costs of $300,000 and provide income or profit of $100,000. Contribution Margin

Contribution Margin Ratio LO 2 Contribution Margin Ratio The contribution margin ratio, sometimes called the profit-volume ratio, indicates the percentage of each sales dollar available to cover fixed costs and to provide income from operations. It is computed as follows: Contribution Margin Ratio = Contribution Margin Sales The contribution margin ratio, sometimes called the profit-volume ratio, indicates the percentage of each sales dollar available to cover fixed costs and to provide income from operations.

Contribution Margin Ratio LO 2 Contribution Margin Ratio The contribution margin ratio is 40% for Lambert Inc., computed as follows: Contribution Margin Ratio = Contribution Margin Sales Contribution Margin Ratio = $400,000 $1,000,000 In some cases, when using cost-volume-profit analysis, managers may prefer to use sales revenue as the measure of sales activity instead of units sold. Contribution Margin Ratio = 40%

Contribution Margin Ratio LO 2 Contribution Margin Ratio 100% 60% 40% 30% 10% Contribution Margin Ratio = Sales – Variable Costs Sales $1,000,000 – $600,000 $1,000,000 Contribution Margin Ratio = The contribution margin is often expressed as a ratio. If sales equal 100% and variable costs equal 60%, the contribution margin ratio equals 40%. Contribution Margin Ratio = 40%

Unit Contribution Margin LO 2 Unit Contribution Margin The unit contribution margin is useful for analyzing the profit potential of proposed decisions. The unit contribution margin is computed as follows: Unit Contribution Margin = Sales Price per Unit Variable Cost per Unit – The unit contribution margin can be useful for analyzing the profit potential of projects. The unit contribution margin is the sales price less the variable cost per unit.

Change in Income from Operations LO 2 Unit Contribution Margin The unit contribution margin is most useful when the increase or decrease in sales volume is measured in sales units (quantities). The change in income from operations can be determined using the following formula: The unit contribution margin is also useful for analyzing the profit potential of proposed decisions. The change in sales volume multiplied by the unit contribution margin equals the change in income from operations. Change in Income from Operations Change in Sales Units = x Unit Contribution Margin

Unit Contribution Margin LO 2 Unit Contribution Margin Lambert Inc.’s sales could be increased by 15,000 units, from 50,000 to 65,000 units. Lambert’s income from operations would increase by $120,000 (15,000 x $8), as shown below. Change in Income from Operations Change in Sales Units = x Unit Contribution Margin If Lambert Inc. could increase its sales by 15,000 units, from 50,000 units to 65,000 units, how much would income from operations increase? Multiplying the increase in units sold of 15,000 units by the unit contribution margin of $8, the expected change to income from operations would be an increase of $120,000. Change in Income from Operations = 15,000 units x $8 = $120,000

Unit Contribution Margin LO 2 Unit Contribution Margin Lambert Inc.’s contribution margin income statement, shown below, confirms that income increased to $220,000 when 65,000 units are sold. At 65,000 units, the total sales revenue is equal to $1,300,000, which results from 65,000 units multiplied by $20 per unit. Total variable costs also increase to $780,000, which equals 65,000 units multiplied by the variable cost per unit of $12.

Unit Contribution Margin LO 2 Unit Contribution Margin 50,000 units 65,000 units Sales ($20) $1,000,000 Variable costs ($12) 600,000 Contribution margin ($8) $ 400,000 Fixed costs 300,000 Income from operations $ 100,000 $1,300,000 780,000 $ 520,000 300,000 $ 220,000 If 15,000 additional units are sold, the total contribution margin will equal $520,000, which is the contribution margin per unit of $8 multiplied by 65,000 units. The per-unit contribution margin is equal to a sale price per unit of $20 less the variable cost per unit of $12. Contribution Margin

Unit Contribution Margin LO 2 Unit Contribution Margin 50,000 units 65,000 units Sales ($20) $1,000,000 Variable costs ($12) 600,000 Contribution margin ($8) $ 400,000 Fixed costs 300,000 Income from operations $ 100,000 $1,300,000 780,000 $ 520,000 300,000 $ 220,000 Therefore, when sales increase by 15,000 units, the income from operations increases by $120,000. Another way to look at this is to realize that since each additional unit sold contributes $8, selling 15,000 more units will increase income from operations by $120,000. $120,000

LO 2 Review Sales (50,000 units) $1,000,000 Variable costs 600,000 Contribution margin $ 400,000 Fixed costs 300,000 Income from operations $ 100,000 100% 60% 40% 30% 10% $20 12 $ 8 The unit contribution margin provides information that can be useful for managers. This information would be useful in considering special advertising or product promotions. Unit contribution margin analyses can provide useful information for managers.

Review LO 2 Sales (50,000 units) $1,000,000 100% $20 60% 40% 30% 10% $20 12 $ 8 Sales (50,000 units) $1,000,000 Variable costs 600,000 Contribution margin $ 400,000 Fixed costs 300,000 Income from operations $ 100,000 The contribution margin may be expressed in three ways: (1) the total contribution margin in dollars is $400,000; (2) the contribution margin is 40% of sales; and (3) the unit contribution margin is $8 per unit. The contribution margin can be expressed in three ways: 1. Total contribution margin in dollars. 2. Contribution margin ratio (percentage). 3. Unit contribution margin (dollars per unit).