Topic 3: Cost–volume–profit relationships (FINAL)

Question 1

What is the contribution approach?

Answer 1

A method of organizing financial information that separates costs into variable and fixed categories. It focuses on calculating the contribution margin.

This approach is commonly used in Cost-Volume-Profit (CVP) analysis, decision-making, and internal reporting to assess how changes in sales, costs, or volume impact profitability.

Question 2

What is Cost-Volume-Profit (CVP) analysis?

Answer 2

A tool for management to understand the interrelationship between cost, volume and profit in an organization by focusing on interactions between the following five elements:
1. Selling prices
2. Volume or level of activity
3. Unit variable costs
4. Total fixed costs
5. Mix of products sold

Question 3

What decisions can managers make using CVP analysis?

Answer 3

CVP helps with decisions about what products to manufacture or sell (product mix), what pricing policy to follow, what marketing strategy to employ, what type of productive facilities to acquire, production levels, and cost structure adjustments etc.

Question 4

What is the contribution statement of profit or loss?

Answer 4

The contribution statement of profit or loss emphasizes the behaviour of costs and therefore is extremely helpful to a manager in judging the impact on profits of changes in selling price, cost or volume.

Organizes costs into variable and fixed categories to calculate the contribution margin. It shows how much revenue contributes to covering fixed costs and generating profit.

Question 5

What is Contribution Margin (CM)?

Answer 5

The difference between sales revenue and variable expenses.
CM = revenue - variable expenses

It represents the amount available to cover fixed expenses and then provide profits for the period.

Question 6

What is the Contribution Margin Ratio (CM Ratio)?

Answer 6

CM Ratio = Contribution Margin / Sales Revenue

It indicates the portion of sales available for covering fixed costs and generating profit​.

It shows how the contribution margin will be affected by a change in total revenue.

For example, a CM ratio of 40%, which means that for each pound increase in revenue, the total contribution margin will increase by 40 pence (£1 revenue × CM ratio of 40%).

Question 7

How can the effect of a change in revenue on the contribution margin be expressed in equation?

Answer 7

Change in contribution margin = CM ratio × Change in revenue

Question 8

What is incremental analysis?

Answer 8

A decision-making approach that focuses on evaluating the financial impact of changes in business activities.

Considers only the items of revenue, cost and volume that will be affected by the changes.

Question 9

What are some applications of CVP concepts?

Answer 9

1. Change in fixed cost and sales volume
2. Change in variable costs and sales volume
3. Change in fixed cost, sales price and sales volume
4. Change in variable cost, fixed cost and sales volume
5. Change in regular sales price

Question 10

Define the break-even point in CVP analysis.

Answer 10

The break-even point is where total revenue equals total costs, resulting in zero profit.

It is calculated as:
Break-even Point = Fixed Costs / Contribution Margin per Unit​.

Question 11

What are two methods to combutate the break-even point?

Answer 11

1. The equation method
   OR
2. The contribution margin
   method

Question 12

How does the equation method combutate the break-even point?

Answer 12

Based on the contribution approach

Revenue = fixed expenses + variable expenses + profit

Here you need to find the sales volume where revnue is equal to fixed and variable expenses (profit is taken out because it is zero)

You solve the equation, hence the name. This can be done for both units and revenue.

Question 13

How does the contribution margin method combutate the break-even point?

Answer 13

Based on the idea that each unit sold provides a certain amount of contribution margin that goes towards covering fixed costs.

Break-even point in units sold = Fixed expenses / Unit contribution margin

Break-even point in total revenue = Fixed expenses / CM ratio

Remember:
Unit sold = CM
Total revenue = CM ratio

Question 14

How is a CVP graph prepared, and what does it show?

Answer 14

Consists of:
1. Horizonal fixed expenses line
2. Total expenses line
3. Total sales revenue line

Break-even is the intersection between line 2 and 3

Area above break-even = profit area
Area below break-even = loss area

Question 15

What is target profit analysis?

Answer 15

Determining the sales volume needed to achieve a target profit.

Question 16

Which methods can be used for a target profit analysis? How?

Answer 16

The CVP equation:
Using the equation method, but instead of solving for the unit sales where profits are zero, you instead solve for the unit sales where profits are at a target amount.

The contribution margin approach:
Units sold to attain the target profit = (Fixed expenses + Target profit) / Unit contribution margin

Question 17

What is the margin of safety? And what is the significance of this in CVP analysis?

Answer 17

The margin of safety measures how much sales can drop before the company incurs a loss (break-even):

Margin of safety = Total budgeted (or actual) revenue − Break-even revenue

OR

Margin of safety percentage = Margin of safety in pounds / Total budgeted (or actual) revenue

A higher margin indicates lower financial risk (greater stability).

Use: A risk assessment tool used to determine the level of “cushion” between actual or projected sales and the sales required to avoid losses. It helps managers plan more effectively and make informed decisions about pricing, cost control, and sales strategies.

Question 18

What is cost structure?

Answer 18

The relative proportion of fixed and variable costs in an organization, and the trade-offs between them.
* A high proportion of fixed costs can lead to higher profit potential at high sales volumes but increases financial risk during low sales periods.
* A high proportion of variable costs offers flexibility and lowers risk during periods of low demand.

Question 19

What is the impact of cost structures on profitability in CVP analysis?

Answer 19

High fixed expenses:
Better if a company want to increase profit.
This is because the CM is higher if the variable costs are low and more profit will be earned by and increase in revenue.

High variable expenses:
Better guarded if revenue decreases.
The is because lower fixed cost gives lower break-even point and therefore a higher margin of safety.

Question 20

What is operating leverage?

Answer 20

A measure of how sensitive profit is to percentage changes in revenue.

Operating leverage acts as a multiplier. If operating leverage is high, a small percentage increase in revenue can produce a much larger percentage increase in profit.

Example: Cinema
* High fixed expenses
* Low variable expenses

If a few tickets are sold, the cinema can barely cover its fixed expenses. If many tickets are sold, most of the additional revenue contributes to proft.

Question 21

What is the degree of operating leverage? And how is it calculated?

Answer 21

A measure, at a given level of revenue, of how a percentage change in sales volume will affect profits.

The degree of operating leverage at a given level of revenue is computed by the following formula:
Degree of operating leverage = Contribution margin / Profit

For example, if the degree of operating leverage is two, the profit grows twice as fast as revenue.
If a hotel’s occupancy increases by 10%, the profit will increase by 20%.

Question 22

How can companies align sales commissions with maximizing profits?

Answer 22

Sales commissions based on sales revenue incentivize salespeople to prioritize products with higher selling prices rather than higher contribution margins.

Companies can tie sales commissions to contribution margins instead of sales revenue.

This encourages salespeople to focus on products that maximize the firm’s profitability, as contribution margin represents the revenue available to cover fixed costs and generate profit.

Question 23

What is the definition of sales mix?

Answer 23

The relative proportions in which a company’s products are sold.

Question 24

Why is sales mix important for profitability?

Answer 24

It is crucial because profits depend on achieving a mix that maximizes total profitability, as different products often have varying profit margins. A greater proportion of high-margin items in the sales mix typically results in higher overall profits.

Question 25

How is customer profitability calculated?

Answer 25

Customer Profitability = Revenue from Customer - Total Cost to Serve Customer.

This includes both direct and indirect costs​.