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Signore Company manufactures and sells a telephone answering machine. The company's contribution format income statement for the most recent year is given below:
Total | Per Unit | Percent of Sales | |
Sales (20,000 units) | $2,400,000 | $120 | 100% |
Less Variable expenses | $1,800,000 | $90 | ? |
Contribution margin | $600,000 | $30 | ? |
Less Fixed expenses | $480,000 | ||
Net income | $120,000 |
Management is anxious to improve the company's profit performance and has asked for several items of information.
Contribution format income statement of Signore Company
Contribution Margin
Contribution margin = Sales – Variable expenses
Contribution margin is the amount available after variable expenses are deducted from sales. The remaining amount is used to meet fixed expenses. If the contribution margin is in excess of fixed expenses, then a profit occurs for the period, if it is not sufficient to cover fixed expenses, then a loss occurs for the period.
CM Ratio / Contribution Margin Ratio
Contribution margin ratio is given by,
Total Contribution Margin / Total Sales
(or)
Per Unit Contribution Margin / Per Unit Sales
Contribution margin ratio indicates the change in contribution margin due to change in total sales. This ratio is useful to managers when they have to take decisions regarding trade-offs between more sales of one product versus sales of another product. Hence products which yield the greatest amount of contribution margin per dollar of sales are emphasized in such situations.
Variable Expense Ratio
Variable expense ratio is given by
Variable expenses / Selling price (or) (1 – Contribution Margin ratio)
Variable expense ratio calculates the costs which vary with production levels; it is used to decide the optimum price for a product.
Break-Even Point
Break-even point is the point where sales covers the total costs, both fixed and variable costs. At this point the company does not make any profit or loss, hence profit or loss equals zero. It can be computed using either the contribution margin method or equation method.
The Equation Method
Profit = Sales – (Variable Expenses + Fixed Expenses)
Using this method we can find break-even sales,
Sales = Variable expenses + Fixed expenses + Profit
At break-even sales, the profit is zero. Hence substitute profit = 0, in the above equation.
The Contribution Margin Method
In units,
Break-even Point (in units sold) = Fixed expenses / Unit Contribution Margin
In dollars,
Break-even Point in Total Sales (in $ made) = Fixed Expenses / CM Ratio
Graphical Representation of Break-Even Point
Target Profit
Target profit analysis is used to find the sales volume to achieve desired/target profit. The equation used to find break-even point using the equation method can be used to find desired profit. For example, let us assume that unit selling price of product X is $100, unit variable expense is $40, and total fixed expenses are $5,000. Then in order to make a profit of $31,000, the required number of units to be sold can be found using the equation as follows.
Sales = Variable expenses + Fixed Expenses + Profit
Let us take number of units as A
Then,
$100 A = $40A + $5,000 + $31,000
$60A = $36,000
A = $36,000 / $60
A = 600 units
Thus, the target profit can be achieved by selling 600 speakers which represent $600,000 in total sales (i.e., $100 * 600).
Margin of Safety
Margin of safety is the surplus of budgeted or actual sales over the break-even sales. The amount by which sales can drop before losses begin to be incurred by the organization can be found using margin of safety.
Margin of Safety = Total Budgeted (or) Actual Sales – Break-even Sales
Degree of Operating Leverage
In order to find the effect of change in sales volume on profits, degree of operating leverage is used. In other words, it is measure used to find the sensitivity of net income to a percentage change in sales. The degree of operating leverage at a given level of sales is given by the following formula:
Degree of operating leverage = Contribution margin / Net income
Steps Used for Solving:
1.a. | CM Ratio = Contribution Margin / Selling Price | |
Contribution margin is $30 | ||
Selling price is $120 | ||
Contribution margin ratio = $30 / $120 | 25% | |
b. | Variable Expense Ratio = Variable Expense / Selling Price | |
Variable expense is $90 | ||
Selling price is $120 | ||
Variable expense ratio = $90 / $120 | 75% |
2 | Using the Equation Method | ||
Break-even point in units | |||
Sales = Variable expenses + Fixed expenses + Profits | |||
Let us assume that number of units sold is Q | |||
Unit selling price | $120 | ||
Unit variable cost | $90 | ||
Fixed expenses | $480,000 | ||
Substituting in the equation, we get | |||
$120Q = $90Q + $480,000 + 0 | |||
$30Q = $480,000 | |||
Q = $480,000 / $30 | 16,000 | units | |
Break-even point in sales dollars | |||
Break-even units | 16,000 | units | |
Unit selling price | $120 | ||
Break-even point in sales dollars = 16,000 units * $120 | $1,920,000 |
3 | Increase in sales | $800,000 |
CM ratio | 25% | |
Expected increase in contribution margin= $800,000 * 25% | $200,000 |
Increase in sales will not result in increase in fixed expenses, it will remain the same, hence the increase in net income will be same as increase in contribution margin, which is, $200,000.
4 | To find target profit, we have to use the equation method. | ||
Sales = Variable expenses + Fixed expenses + Profits | |||
Unit selling price | $120 | ||
Unit variable cost | $90 | ||
Fixed expenses | $480,000 | ||
Target profit | $180,000 | ||
Substituting in the equation, we get | |||
$120Q = $90Q + $480,000 + $180,000 | |||
$30Q = $660,000 | |||
Q = $660,000 / $30 | 22000 | units |
Therefore, the required number of units to be sold in order to achieve a target profit of $180,000 is 22,000 units.
5 | Margin of Safety = Total Sales - Break-even Sales | |
Total sales (from the data provided) | $2,400,000 | |
Break-even sales ( from 2 above) | $1,920,000 | |
Margin of safety = $2,40,0000 - $1,920,000 | $480,000 |
6 | Degree of Operating Leverage = Contribution Margin / Net Income | |
Contribution margin | $600,000 | |
Net income | $120,000 | |
Therefore, degree of operating leverage is $600,000 / $120,000 | 5 |
Direct Cost | Expired Cost | Fixed Cost | Full Cost | ||||
Non Manufacturing Cost | Manufacturing Cost | Indirect Cost | Incremental Cost | ||||
Period Cost | Variable Cost | Business Level Cost | Business Level Or Sustaining Cost | ||||
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