The contribution margin ratio indicates by how much every dollar of sales will increase income.
Alternatively, the contribution margin ratio can be determined by dividing the unit contribution margin by the unit selling price. For Vargo Video, the ratio is as follows.
Unit Contribution Margin÷Unit Selling Price=Contribution Margin Ratio$200÷$500=40%Unit Contribution Margin÷Unit Selling Price=Contribution Margin Ratio$200÷$500=40%
ILLUSTRATION 18-17 Formula for contribution margin ratio
The contribution margin ratio of 40% means that Vargo generates 40 cents of contribution margin with each dollar of sales. That is, $0.40 of each sales dollar (40%×$1)(40%×$1) is available to apply to fixed costs and to contribute to net income.
This expression of contribution margin is very helpful in determining the effect of changes in sales on net income. For example, if Vargo’s sales increase $100,000, net income will increase $40,000 (40%×$100,000)$40,000 (40%×$100,000). Thus, by using the contribution margin ratio, managers can quickly determine increases in net income from any change in sales.
We can also see this effect through a CVP income statement. Assume that Vargo’s current sales are $500,000 and it wants to know the effect of a $100,000 (200‐unit) increase in sales. Vargo prepares a comparative CVP income statement analysis as follows.
|VARGO VIDEO COMPANY|
CVP Income Statements
For the Month Ended June 30, 2017
|No Change||With Change|
|Total||Per Unit||Percent of Sales||Total||Per Unit||Percent of Sales|
|Net income||$ –0–||$40,000|
ILLUSTRATION 18-18 Comparative CVP income statements
The $40,000 increase in net income can be calculated on either a unit contribution margin basis (200 units×$200 per unit)(200 units×$200 per unit) or using the contribution margin ratio times the increase in sales dollars (40%×$100,000)(40%×$100,000). Note that the unit contribution margin and contribution margin as a percentage of sales remain unchanged by the increase in sales.
Study these CVP income statements carefully. The concepts presented in these statements are used extensively in this and later chapters.
DO IT! 3
CVP Income Statement
Ampco Industries produces and sells a cell phone‐operated thermostat. Information regarding the costs and sales of thermostats during September 2017 are provided below.
|Unit selling price of thermostat||$85|
|Unit variable costs||$32|
|Total monthly fixed costs||$190,000|
Prepare a CVP income statement for Ampco Industries for the month of September. Provide per unit values and total values.
✓ Provide a heading with the name of the company, name of statement, and period covered.
✓ Subtract variable costs from sales to determine contribution margin. Subtract fixed costs from contribution margin to determine net income.
✓ Express sales, variable costs and contribution margin on a per unit basis.
CVP Income Statement
For the Month Ended September 30, 2017
|Net income||$ 22,000|
Related exercise material: BE18-6, BE18-7, E18-7, and DO IT! 18-3.
LEARNING OBJECTIVE 4
Compute the break‐even point using three approaches.
A key relationship in CVP analysis is the level of activity at which total revenues equal total costs (both fixed and variable)—the break‐even point. At this volume of sales, the company will realize no income but will suffer no loss. The process of finding the break‐even point is called break‐even analysis. Knowledge of the break‐even point is useful to management when it considers decisions such as whether to introduce new product lines, change sales prices on established products, or enter new market areas.
The break‐even point can be:
1. Computed from a mathematical equation.
2. Computed by using contribution margin.
3. Derived from a cost‐volume‐profit (CVP) graph.
The break‐even point can be expressed either in sales units or sales dollars.
Break‐even analysis indicates the amount of sales units or sales dollars that a company needs to cover its costs.