Break even point and contribution margin analysis, also known as cost-volume-profit (CVP) analysis, helps managers perform many useful analyses. It deals with how profit and costs change with a change in volume. More specifically, it looks at the effects on profits of changes in such factors as variable costs, fixed costs, selling prices, volume, and mix of products sold. By studying the relationships of costs, sales, and net income, management is better able to cope with many planning decisions. Break-even analysis determines the break-even sales. Break-even point—the financial crossover point when revenues exactly match costs—does not show up in corporate earnings reports, but managers find it an extremely useful measurement in a variety of ways .
Through this post, I am going to demonstrate various break even point and contribution margin analysis in details with load of case examples. It’s not merely about break even point and contribution margin formula and calculation, it is also about the concept and the tax effect. Enjoy!
Questions Answered by Break-even and Contribution Margin Analysis
Break-even and contribution margin analysis tries to answer these five questions :
- What sales volume is required to break even?
- What sales volume is necessary to earn a desired profit?
- What profit can be expected on a given sales volume?
- How would changes in selling price, variable costs, fixed costs, and output affect profits?
- How would a change in the mix of products sold affect the break-even and target income volume and profit potential?
Contribution Margin Income Statement
The traditional income statement for external reporting shows the functional classification of costs, that is, manufacturing costs versus non-manufacturing expenses (or operating expenses). An alternative format of income statement, known as the contribution margin income statement, organizes the costs by behavior rather than by function. It shows the relationship of variable costs and fixed costs a given cost item is associated with, regardless of the functions .
The contribution approach to income determination provides data that are useful for managerial planning and decision making. The statement highlights the concept of contribution margin, which is the difference between sales and variable costs. The traditional format emphasizes the concept of gross margin, which is the difference between sales and
cost of goods sold.
These two concepts are independent and have nothing to do with each other. Gross margin is available to cover non-manufacturing expenses, whereas contribution margin is available to cover fixed costs. A comparison is made between the traditional format and the contribution format below :
Contribution Margin [Concept—Formula—Case Examples]
For accurate break-even and contribution margin analysis, a distinction must be made between costs as being either variable or fixed. Mixed costs must be separated into their variable and fixed components .
In order to compute the break-even point and perform various break-even and contribution margin analyses, note these important concepts:
Contribution Margin (CM). The contribution margin is the excess of sales (S) over the variable costs (VC) of the product or service. It is the amount of money available to cover fixed costs (FC) and to generate profit. Symbolically, CM = S – VC.
Unit CM. The unit CM is the excess of the unit selling price (p) over the unit variable cost (v). Symbolically, unit CM = p – v.
CM Ratio . The CM ratio is the contribution margin as a percentage of sales, that is:
CM ratio = CM/S = [S-VC]/s = 1-[VC/S]
The CM ratio can also be computed using per-unit data :
CM ratio = Unit CM/p = [p-v]/p = 1-[v/p]
Note. that the CM ratio is 1 minus the variable cost ratio. For example, if variable costs account for 70 percent of the price, the CM ratio is 30 percent.
To illustrate the various concepts of CM, consider these data :
CM = S – VC = $37,500-$15,000 = $22,500
Unit CM = p-v = $25 – $10 = $15
CM Ratio = CM/S= $22,500/$37,500 = 60% 0r Unit CM/p = $15/$25 = 0.6 = $60%
Break-even Point Analysis
The break-even point represents the level of sales revenue that equals the total of the variable and fixed costs for a given volume of output at a particular capacity use rate. For example, one might want to ask the break-even occupancy rate (or vacancy rate) for a hotel or the break-even load rate for an airliner .