Cost and Management Accounting

PGP-23 (2019-2020)
Instructor: Prof. Qambar Abidi

Where the mind is without fear and the head is held high - Tagore, R. (1910), Gitanjali.
Cost-Volume-Profit (CVP) Analysis

(Garrison et al. Chapter 5)

1
Emma Jones

• Emma Jones is a young entrepreneur who recently used GMAT Success, a

test-prep book and software package for the business school admission
test. Emma loved the book and program so much that after graduating she
signed a contract with GMAT Success’s publisher to sell the learning
materials. She recently sold them at a college fair in Boston and is now
thinking of selling them at a college fair in Chicago

IIM K - Cost and Management Accounting 2

Emma Jones

• Emma can purchase each package (book and software) from the publisher
for $120 per package, with the privilege of returning all unsold packages
and receiving a full $120 refund per package. Emma can sell the package
at $200 a piece. However, she must pay $2,000 to rent a booth at the fair.
She will incur no other costs. Should she rent the booth or not?

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• To answer the question, we need to understand the profitability of
Emma’s business which would depend on her profitability, which in turn
depends on costs, sales price, sales volume and their inter-relationship.

• CVP analysis is useful in answering these questions.

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1. Objective of CVP analysis

• CVP analysis is used to analyse the behaviour of and relation between total cost, total
revenue and income, as changes occur in

• Number of units sold

• Selling price per unit

• Variable cost per unit

• Fixed cost of a product

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• CVP analysis is used to analyse the behaviour of and relation between total cost, total
revenue and income, as changes occur in

• Number of units sold

Revenue (= No of units sold * Selling price per unit)
• Selling price per unit

• Variable cost per unit

• Fixed cost of a product

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• CVP analysis is used to analyse the behaviour of and relation between total cost, total
revenue and income, as changes occur in

• Number of units sold

• Selling price per unit Variable cost (= No of units sold * Variable price per unit)

• Variable cost per unit

• Fixed cost of a product

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• CVP analysis is used to analyse the behaviour of and relation between total cost, total
revenue and income, as changes occur in

• Number of units sold

• Selling price per unit

Total cost (= {Total variable cost} + Fixed Cost)
• Variable cost per unit = ({No of units sold * Variable price per unit}
+ Fixed Cost)
• Fixed cost of a product

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• CVP analysis is used to analyse the behaviour of and relation between total cost, total
revenue and income, as changes occur in

• Number of units sold

• Selling price per unit

Income = Total revenue – Total cost
• Variable cost per unit

• Fixed cost of a product

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2. Source of cost, revenue and income information

• Income statement (Traditional)

Income Statement for XYZ Co. for year ended 31st March, 2019
Total
Revenue ₹₹
Cost of Goods sold ₹₹
Gross margin ₹₹
Selling and Administrative expenses ₹₹
Net operating income ₹₹

• Limitation: No information about the fixed and variable cost components

IIM K - Cost and Management Accounting 10

• Income statement (Contribution)
Contribution Income Statement for XYZ Co. for year ended 31st March, 2019
Total Per unit
Revenue ₹ ₹
Variable expenses ₹ ₹
Contribution margin ₹ ₹
Fixed expenses ₹ ₹
Net operating income ₹ ₹

• Breakup of expenses in to fixed and variable component

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• Income statement (Contribution)

Contribution Income Statement for XYZ Co. for year ended 31st March, 2019
Total Per unit
Revenue ₹ ₹
Variable expenses ₹ ₹
Contribution margin ₹ ₹
Fixed expenses ₹ ₹
Net operating income ₹ ₹

• Contribution Margin: Income (revenues – variable expenses) available to cover fixed

expenses first, and then the residual generates operating income.

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 • Income statement (Contribution)

Contribution Income Statement for XYZ Co. for year ended 31st March, 2019
Total Per unit
Revenue = Selling price per unit *# units sold
Variable expenses = Variable price per unit * # units sold
Contribution margin
Fixed expenses
Net operating income

• Total Revenue and Total Variable expense, increase with number of units sold.

IIM K - Cost and Management Accounting 13

 • Income statement (Contribution)

Contribution Income Statement for XYZ Co. for year ended 31st March, 2019
Total Per unit
Revenue = Selling price per unit *# units sold
Variable expenses = Variable price per unit * # units sold
Contribution margin = Revenue – Variable expenses
Fixed expenses
Net operating income

• Contribution margin is proportional to the units sold

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 • Income statement (Contribution)

Contribution Income Statement for XYZ Co. for year ended 31st March, 2019
Total Per unit
Revenue = Selling price per unit *# units sold = Total Revenue/ # units sold
Variable expenses = Variable price per unit * # units sold = Variable expenses/# units
sold
Contribution margin = Revenue – Variable expenses = (Revenue – Variable
expenses)/# units sold
Fixed expenses
Net operating income

IIM K - Cost and Management Accounting 15

 • Income statement (Contribution)

Contribution Income Statement for XYZ Co. for year ended 31st March, 2019
Total Per unit
Revenue = Selling price per unit *# units sold = Total Revenue/ # units sold
Variable expenses = Variable price per unit * # units sold = Variable expenses/# units
sold
Contribution margin = Revenue – Variable expenses = (Revenue – Variable
expenses)/# units sold
Fixed expenses ₹
Net operating income = Revenue - Variable expenses - Fixed expenses
= Contribution margin - Fixed expenses
IIM K - Cost and Management Accounting 16
Emma Jones

Number of packages sold

0 1 5 25 40
Revenues 200 Per unit 0 200 1000 5000 8000
Variable costs 120 Per unit 0 120 600 3000 4800
Contribution margin 80 Per unit 0 80 400 2000 3200
Fixed costs 2000 Per unit 2000 2000 2000 2000 2000
Operating income -2000 -1920 -1600 0 1200

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3.1 CVP relationship (equation)

Operating Income = Contribution margin (Total) – Fixed costs

where,

Contribution margin = Revenues – Variable Costs, and

Contribution margin per unit = Contribution margin/ Number of units

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Example 1

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin ?
Fixed expenses 6,000
Net operating income

What is the contribution margin and contribution margin per unit?

contribution margin = Sales - Variable expenses = 8,000
contribution margin per unit = 8000/ 1000 = 8

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 Operating Income = Contribution margin (Total) – Fixed costs

where,

Contribution margin = Revenues – Variable Costs, and

Contribution margin per unit = Contribution margin/ Number of units

Also,

Contribution margin ratio (percentage) = ContribuAon margin/ Revenues

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And,

Contribution margin ratio = 1 - Variable expense ratio

Where,

Variable expense ratio (percentage) = Variable expense/Revenues

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Example 2

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin
Fixed expenses 6,000
Net operating income

What is the contribution margin ratio?

IIM K - Cost and Management Accounting 22

Example 2

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin 8,000
Fixed expenses 6,000
Net operating income 2,000

contribution margin ratio = contribution margin/ Sales

= 8000/ 20000 = 40%

IIM K - Cost and Management Accounting 23

Example 3

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin
Fixed expenses 6,000
Net operating income

What is the variable expense ratio?

IIM K - Cost and Management Accounting 24

Example 3

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin 8,000
Fixed expenses 6,000
Net operating income 2,000

Variable expense ratio = variable expense / Sales

= 12000/ 20000 = 60%

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Example 4

• Last month when Holiday Creations, Inc., sold 50,000 units, total sales were $200,000,
total variable expenses were $120,000, and fixed expenses were $65,000.

What is the company’s contribution margin ratio?

IIM K - Cost and Management Accounting 26

Example 4

• Last month when Holiday Creations, Inc., sold 50,000 units, total sales were $200,000,
total variable expenses were $120,000, and fixed expenses were $65,000.

!"#$%&'"()"*#$ +,%- .//,///&1./,///

Contribution margin ratio = = =40%
!"#$% .//,///

IIM K - Cost and Management Accounting 27

Emma Jones

• Emma can purchase each package (book and software) from the publisher
for $120 per package, with the privilege of returning all unsold packages
and receiving a full $120 refund per package. Emma can sell the package
at $200 a piece. However, she must pay $2,000 to rent a booth at the fair.
She will incur no other costs.

Should she for 500, advertise if her sales are expected to grow from 40 to
44 units?

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3.2 CM Ratio and decision making

Change in CM = CM ratio * Change in sales

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 Change in CM = CM ratio * Change in sales

Net Operating Profit = CM ratio *  Sales  − Fixed expenses

IIM K - Cost and Management Accounting 30

Example 5

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin 8,000
Fixed expenses 6,000
Net operating income 2,000

If sales increase to 1,001 units, what would be the increase in net operating income?

IIM K - Cost and Management Accounting 31

Example 5

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000 20,020
Variable expenses 12,000 12,012
Contribution margin 8,000 8,008
Fixed expenses 6,000 6,000
Net operating income 2,000 2,008

If sales increase to 1,001 units, what would be the increase in net operating income?
Change in operating income = Change in (CM ratio* sales) – change in fixed income
= 0.4*(20020-20000) = 8

IIM K - Cost and Management Accounting 32

Example 6

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin 8,000
Fixed expenses 6,000
Net operating income 2,000
If an advertisement campaign Rs.500 is expected to increases sales by 50 units, should
the firm pay for the campaign?

IIM K - Cost and Management Accounting 33

Example 6

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000 21,000
Variable expenses 12,000 12,600
Contribution margin 8,000 8,400
Fixed expenses 6,000 6,500
Net operating income 2,000 1,900
If an advertisement campaign Rs.500 is expected to increases sales by 50 units, should
the firm pay for the campaign?
Change in operating income = change in (CM ratio* sales) – Change in Fixed expenses
= (0.4)*(20*1050-20*1000) – (6500-6000) = -100

IIM K - Cost and Management Accounting 34

Example 7

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin 8,000
Fixed expenses 6,000
Net operating income 2,000
If improvement in product quality increase the variable cost by 10%, but at the same
time increases sales by 10%, should the firm opt for this change?

IIM K - Cost and Management Accounting 35

Example 7

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000 22,000
Variable expenses 12,000 13,200
Contribution margin 8,000 8,800
Fixed expenses 6,000 6,000
Net operating income 2,000 2,800
If improvement in product quality increase the variable cost by 10%, but at the same
time increases sales by 10%, should the firm opt for this change?
Change in CM = Change in (CM ratio* sales) – change in fixed expenses
= (0.4)*(22000-20000) = +800

IIM K - Cost and Management Accounting 36

Example 8

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin 8000
Fixed expenses 6,000
Net operating income 2000
If reduction in sales price by Rs. 2 per unit and increase in advertising spend by Rs. 500
is expected to increase sales volume by 20%, should the firm opt for this change?

IIM K - Cost and Management Accounting 37

Example 8

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000 21,600
Variable expenses 12,000 14,400
Contribution margin 8000 7,200
Fixed expenses 6,000 6,500
Net operating income 2000 700
If reduction in sales price by Rs. 2 per unit and increase in advertising spend by Rs. 500 is
expected to increase sales volume by 20%, should the firm opt for this change?
Change in operating income = Change in (CM ratio* sales) – Change in Fixed expenses
= {(7200/21600)*(1200*18)-(8000/20000)*( 1000*20)} – (6500-6000) = -1,300

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Emma Jones

Change in operating income = Change in (CM ratio* sales) – Change in Fixed

expenses

Decision 1:

Change in operating income = 3200/8000*(44*200-40*200)-(2500-2000)

= -180

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3.3 CVP relationship (Graphical)

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3.4 CVP relationship (Assumptions)

• Changes in revenues and costs arise only because of changes in the number of product
(or service) units sold.

• Total costs can be separated into two components: a fixed component that does not
vary with units sold and a variable component that changes based on units sold.

• When represented graphically, the behaviours of total revenues and total costs are
linear in relation to units sold within a relevant range (and time period).

• Selling price, variable cost per unit, and total fixed costs (within a relevant range and
time period) are known and constant.

IIM K - Cost and Management Accounting 41

3.5 CVP relationship (important consideration)

• For classifying costs as variable or fixed always consider:

• the relevant range,

• the length of the time horizon and

• the specific decision situation.

IIM K - Cost and Management Accounting 42

Emma Jones

• Emma can purchase each package (book and software) from the publisher
for $120 per package, with the privilege of returning all unsold packages
and receiving a full $120 refund per package. Emma can sell the package
at $200 a piece. However, she must pay $2,000 to rent a booth at the fair.
She will incur no other costs.

How Sales much should Emma target, so that she does loose or make any
money?

IIM K - Cost and Management Accounting 43

4. Breakeven point

• Quantity of output sold at which total revenues equal total costs

= the quantity of output sold that results in zero operating income.

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• Quantity of output sold at which total revenues equal total costs

= the quantity of output sold that results in zero operating income.

Fixed costs
Breakeven point (# of units) =
Contribu:on margin per unit

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Breakeven point

• Quantity of output sold at which total revenues equal total costs

= the quantity of output sold that results in zero operating income.

Fixed costs
Breakeven point (# of units) =
Contribu:on margin per unit

Fixed costs
Breakeven point (revenues) =
Contribu:on margin ra:o

IIM K - Cost and Management Accounting 46

Breakeven point (graphically)

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Example 9

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin
Fixed expenses 6,000
Net operating income

What is the break-even point in unit sales?

IIM K - Cost and Management Accounting 48

Example 9

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin 8,000
Fixed expenses 6,000
Net operating income 2,000

Fixed costs 6000

Breakeven point (# of units) = = =750 units
ContribuEon margin per unit 8

IIM K - Cost and Management Accounting 49

Example 10

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin
Fixed expenses 6,000
Net operating income

What is the break-even revenue?

IIM K - Cost and Management Accounting 50

Example 10

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin 8,000
Fixed expenses 6,000
Net operating income 2,000

Fixed costs 6000

Breakeven point (# of units) = = = $ 15,000
ContribuEon margin raEo 0.4

IIM K - Cost and Management Accounting 51

Example 11

• Karlik Enterprises distributes a single product whose selling price is $24 per unit and
whose variable expense is $18 per unit. The company’s monthly fixed expense is
$24,000. Calculate the company’s break-even point in unit sales.

IIM K - Cost and Management Accounting 52

Example 11

• Karlik Enterprises distributes a single product whose selling price is $24 per unit and
whose variable expense is $18 per unit. The company’s monthly fixed expense is
$24,000. Calculate the company’s break-even point in unit sales.

Fixed costs 24000

Breakeven point (# of units) = ContribuMon margin per unit = $%&'( = 4000 units

IIM K - Cost and Management Accounting 53

Emma Jones

• Emma can purchase each package (book and software) from the publisher
for $120 per package, with the privilege of returning all unsold packages
and receiving a full $120 refund per package. Emma can sell the package
at $200 a piece. However, she must pay $2,000 to rent a booth at the fair.
She will incur no other costs.

How Sales much should Emma target, so that she does loose or make any
money?

IIM K - Cost and Management Accounting 54

Emma Jones

Emma’s break-even sales volume = fixed cost/ contribution margin per unit

= 2000/80 = 25 units

Emma’s break-even sales = fixed cost/ contribution margin ratio

= 2000/(80/200) = $ 5000

IIM K - Cost and Management Accounting 55

Emma Jones

• Emma can purchase each package (book and software) from the publisher
for $120 per package, with the privilege of returning all unsold packages
and receiving a full $120 refund per package. Emma can sell the package
at $200 a piece. However, she must pay $2,000 to rent a booth at the fair.
She will incur no other costs.

How much Sales should Emma target, if she needs an operating profit of
5000?

IIM K - Cost and Management Accounting 56

5. Target Operating Income

Fixed costs + Target opera8ng Income

Target point (# of units) = Contribu8on margin per unit

Fixed costs + Target opera8ng Income

Target point (revenues) = Contribu8on margin ra8o

IIM K - Cost and Management Accounting 57

Example 12

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin 8,000
Fixed expenses 6,000
Net operating income 2,000

What is the unit sales to achieve target profit of 5000?

IIM K - Cost and Management Accounting 58

Example 12

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin 8,000
Fixed expenses 6,000
Net operating income 2,000

What is the unit sales to achieve target profit of 5000?

Fixed costs !"#$%&' ($)*+' 6000+5000
Target point (# of units) = CM per unit = 8 = 1375 units

IIM K - Cost and Management Accounting 59

Emma Jones

• Emma can purchase each package (book and software) from the publisher
for $120 per package, with the privilege of returning all unsold packages
and receiving a full $120 refund per package. Emma can sell the package
at $200 a piece. However, she must pay $2,000 to rent a booth at the fair.
She will incur no other costs.

How much Sales should Emma target, if she needs an operating profit of
5000?

IIM K - Cost and Management Accounting 60

Emma Jones

Emma’s target profit sales volume = (fixed cost + target profit) / contribution
argin per unit

= (2000+5000)/80 = 88 units

Emma’s target profit sales = (fixed cost + target profit / contribution margin
ratio

= (2000+5000)/(80/200) = $ 17,500

IIM K - Cost and Management Accounting 61

Emma Jones

• Emma can purchase each package (book and software) from the publisher
for $120 per package, with the privilege of returning all unsold packages
and receiving a full $120 refund per package. Emma can sell the package
at $200 a piece. However, she must pay $2,000 to rent a booth at the fair.
She will incur no other costs.

How much Sales should Emma target, if she needs an net income of 3000?

Given that tax rate = 40%

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6. Target Net Income

• Net income = Operating income – Income taxes {+/- non-operating revenues and costs}

IIM K - Cost and Management Accounting 63

Emma Jones

Emma’s target operating profit = Emma’s target net profit/(1-tax rate)

= 3000/ (1-0.4) = 5000
Emma’s target operating profit sales volume = (fixed cost + target operating
profit) / contribution margin per unit = (2000+ 5000)/80 = 88 units

Emma’s target operating profit sales = (fixed cost + target operating profit) /
contribution margin ratio = (2000+ 5000)/(80/200) = $ 17,500

IIM K - Cost and Management Accounting 64

Emma Jones

• Emma can purchase each package (book and software) from the publisher
for $120 per package, with the privilege of returning all unsold packages
and receiving a full $120 refund per package. Emma can sell the package
at $200 a piece. However, she must pay $2,000 to rent a booth at the fair.
She will incur no other costs.

If Emma sales 30 units, then how much buffer does she have before she
makes a operating loss?

IIM K - Cost and Management Accounting 65

7. Margin of safety

• Excess of budgeted or actual sales dollars over the breakeven volume of sales dollars

Margin of safety = Revenue – Break even Revenue

IIM K - Cost and Management Accounting 66

Example 13

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin 8,000
Fixed expenses 6,000
Net operating income 2,000

What is the margin of safety in dollars?

IIM K - Cost and Management Accounting 67

Example 13

Oslo Company prepared the following contribution format income statement based on a
sales volume of 1,000 units:
Sales 20,000
Variable expenses 12,000
Contribution margin 8,000
Fixed expenses 6,000
Net operating income 2,000

Margin of safety = Revenue – Break even Revenue = 20000 - 6000/0.4 = 5,000

IIM K - Cost and Management Accounting 68

Emma Jones

• Emma can purchase each package (book and software) from the publisher
for $120 per package, with the privilege of returning all unsold packages
and receiving a full $120 refund per package. Emma can sell the package
at $200 a piece. However, she must pay $2,000 to rent a booth at the fair.
She will incur no other costs.

If Emma sales 30 units, then how much buffer does she have before she
makes a operating loss?

IIM K - Cost and Management Accounting 69

Margin of safety = Revenue – Break even Revenue

= 30*200 – 2000/(80/200)

= 1000

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Emma Jones

• If the Chicago fair organizers offer Emma three rental alternatives:

• Option 1: $2,000 fixed fee

• Option 2: $800 fixed fee plus 15% of GMAT Success revenues

• Option 3: 25% of GMAT Success revenues with no fixed fee

Which option should Emma choose

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8. Cost Structure – Fixed vs. Variable cost

• Decision under following condition:

• Using the current data

• With bullish sentiment

• With bearish sentiment

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• Guidelines

• Using the current data choose the option with better operating income.

IIM K - Cost and Management Accounting 73

Example 14

• Two farms A and B, both harvest strawberries, but have different operating models. A
relies on migrant workers to pick the fruits, while B bought expensive machinery to do
the picking.
Farm 1 Farm 2
Amount % Amount %
Sales 100,000 100,000
Variable expenses 60,000 60% 30,000 30%
Fixed expenses 30,000 62,000

Identify the farm A and B from above data and find which farm is following a better
strategy

IIM K - Cost and Management Accounting 74

Example 14

• Two farms A and B, both harvest strawberries, but have different operating models. A
relies on migrant workers to pick the fruits, while B bought expensive machinery to do
the picking.
Farm A Farm B
Amount % Amount %
Sales 100,000 100,000
Variable expenses 60,000 60% 30,000 30%
Contribution margin 40,000 40% 70,000 70%
Fixed expenses 30,000 62,000
Net operating income 10,000 8,000

IIM K - Cost and Management Accounting 75

• Guidelines

• Using the current data choose the option with better operating income.

• With bullish sentiment

- Choose the option with higher CM ratio.

- Higher capacity (as indicated by higher fixed cost)

IIM K - Cost and Management Accounting 76

Example 15

• Two farms A and B, both harvest strawberries, but have different operating models. A
relies on migrant workers to pick the fruits, while B bought expensive machinery to do
the picking.
Farm A Farm B
Amount % Amount %
Sales 100,000 100,000
Variable expenses 60,000 60% 30,000 30%
Fixed expenses 30,000 62,000

If the sales are expected to increase by 50%, then which of the two farm is a better
choice?

IIM K - Cost and Management Accounting 77

Example 15

• Two farms A and B, both harvest strawberries, but have different operating models. A
relies on migrant workers to pick the fruits, while B bought expensive machinery to do
the picking.
Farm A Farm B
Amount % Amount %
Sales 150,000 150,000
Variable expenses 90,000 60% 45,000 30%
Contribution margin 60,000 40% 105,000 70%
Fixed expenses 30,000 62,000
Net operating income 30,000 43,000

IIM K - Cost and Management Accounting 78

• Guidelines

• Using the current data choose the option with better operating income.

• With bullish sentiment

- Choose the option with higher CM ratio.

- Higher capacity (as indicated by higher fixed cost)

• With bearish sentiment

- Choose the option with higher Margin of Safety.

- Lower fixed cost and higher variable cost

IIM K - Cost and Management Accounting 79
• Two farms A and B, both harvest strawberries, but have different operating models. A
relies on migrant workers to pick the fruits, while B bought expensive machinery to do
the picking.
Farm A Farm B
Amount % Amount %
Sales 100,000 100,000
Variable expenses 60,000 60% 30,000 30%
Fixed expenses 30,000 62,000

If the sales are expected to decrease by 50%, then which of the two farm is a better
choice?

IIM K - Cost and Management Accounting 80

• Two farms A and B, both harvest strawberries, but have different operating models. A
relies on migrant workers to pick the fruits, while B bought expensive machinery to do
the picking.
Farm A Farm B
New Old New Old
Sales 50,000 100,000 50,000 100,000
Variable expenses 30,000 60% 60,000 60% 15,000 30% 30,000 30%
Contribution margin 20,000 40% 40,000 40% 35,000 70% 70,000 70%
Fixed expenses 30,000 30,000 62,000 62,000
Net operating income -10,000 10,000 -27,000 8,000
Margin of Safety 25,000 11,429

IIM K - Cost and Management Accounting 81

Emma Jones

Number of packages
sold=30
Op. 1 Op. 2 Op. 3
Revenues 200 Per unit 6000 6000 6000
Variable costs 120+ Per unit 3600 4500 5100
Contribution margin 2400 1500 900
Fixed costs 2000 800 0
Operating income 400 700 900
IIM K - Cost and Management Accounting 82
9. Operating Leverage

Measure of sensitivity of operating income to change in units sold & contribution margin.

IIM K - Cost and Management Accounting 83

9. Operating Leverage

Measure of sensitivity of operating income to change in units sold & contribution margin.

/%+)$*01)*%+ 2($#*+
!"#$"" %& %'"$()*+# ,"-"$(#" =
3'"$()*+# *+4%2"

IIM K - Cost and Management Accounting 84

9. Operating Leverage

Measure of sensitivity of operating income to change in units sold & contribution margin.

/%+)$*01)*%+ 2($#*+
!"#$"" %& %'"$()*+# ,"-"$(#" =
3'"$()*+# *+4%2"

• Higher the degree of operating leverage, more is the increase (decrease) in net
operating income for increase (decrease) in unit sales.

% 46(+#" *+ %'"$()*+# *+4%2" = 3'"$()*+# ,"-"$(#" ∗ % 46(+#" *+ +") 8(,"8

IIM K - Cost and Management Accounting 85

9. Operating Leverage

Measure of sensitivity of operating income to change in units sold & contribution margin.

/%+)$*01)*%+ 2($#*+
!"#$"" %& %'"$()*+# ,"-"$(#" =
3'"$()*+# *+4%2"

• Higher the degree of operating leverage, more is the increase (decrease) in net
operating income for increase (decrease) in unit sales.

% 46(+#" *+ %'"$()*+# *+4%2" = 3'"$()*+# ,"-"$(#" ∗ % 46(+#" *+ +") 8(,"8

Operating leverage describes the effect of fixed cost on operating income.

IIM K - Cost and Management Accounting 86

10. CVP analysis for multi-product company (Sales mix)

• Firm’s sales mix has an impact on firm’s net operating income, as different products
may have varying contribution margin.

• Firm’s respond to changing market conditions by varying the sales mix, as it changes
the firm’s break-even point

IIM K - Cost and Management Accounting 87

 Prod. A Prod. B Total
Units sold 60 40 100
Selling price per unit 200 100
Variable cost per unit 120 70

Calculate the firms break-even sales mix

IIM K - Cost and Management Accounting 88
 Prod. A Prod. B Total
Sales 12,000 4,000 16,000
Variable expenses 7,200 2,800 10,000
Contribution margin 4,800 1,200 6,000
Fixed cost 4500
Operating income 1500

Break even firm revenue = Fixed Cost/ CM ratio

= 4500/ (6000/16000) = 12,000
Assuming sales mix remains constant (A:B=12000:4000=3:1)
Implies, For break-even, Sales of A = 9,000 and Sales of B = 3,000
Implies, Break-even sales unit of A = 9000/200 = 45
Break-even sales unit of B = 3000/100 = 30
IIM K - Cost and Management Accounting 89
Practise question 1

• Wembley Travel Agency specializes in flights between Los Angeles and London. It books
passengers on United Airlines at $900 per round-trip ticket. Until last month, United paid
Wembley a commission of 10% of the ticket price paid by each passenger. This commission was
Wembley’s only source of revenues. Wembley’s fixed costs are $14,000 per month (for salaries,
rent, and so on), and its variable costs, such as sales commissions and bonuses, are $20 per
ticket purchased for a passenger. United Airlines has just announced a revised payment
schedule for all travel agents. It will now pay travel agents a 10% commission per ticket up to a
maximum of $50. Any ticket costing more than $500 generates only a $50 commission,
regardless of the ticket price. Wembley’s managers are concerned about how United’s neo
payment schedule will affect its breakeven point and profitability.

IIM K - Cost and Management Accounting 90

part 1

• Under the old 10% commission structure, how many round-trip tickets must
Wembley sell each month (a) to break even and (b) to earn an operating income of
$7,000?

IIM K - Cost and Management Accounting 91

part 1

• Under the old 10% commission structure, how many round-trip tickets must
Wembley sell each month (a) to break even and (b) to earn an operating income of
$7,000?
Solution
Breakeven number of tickets = Fixed cost/ CM per unit
= 14000/ (90-20) = 200
Units sold for operating income = (Fixed cost + target income)/ CM per unit
= 21000/ (90-20) = 300

IIM K - Cost and Management Accounting 92

part 2

• How does United’s revised payment schedule affect your answers to (a) and (b) in
requirement 1?

IIM K - Cost and Management Accounting 93

part 2

• How does United’s revised payment schedule affect your answers to (a) and (b) in
requirement 1?

Solution

Breakeven number of tickets = Fixed cost/ CM per unit

= 14000/ (50-20) = 467

Units sold for operating income = (Fixed cost + target income)/ CM per unit

= 21000/ (50-20) = 700

IIM K - Cost and Management Accounting 94

Practise question 2

• Piedmont Fasteners makes three different clothing fasteners in its manufacturing

facility in North Carolina. Total fixed expenses are $400,000 per year. All three products
are sold in highly competitive markets, so the company is unable to raise prices
without losing an unacceptable numbers of customers. The company has an extremely
effective lean production system, so there are no beginning or ending work in process
or finished goods inventories. Data concerning these products appear below:
Velcro Metal Nylon
Annual sales volume 100,000 200,000 400,000
Unit selling price 1.65 1.50 $ 0.85
Variable expense per unit 1.25 0.70 $ 0.25
IIM K - Cost and Management Accounting 95
• 1. What is the company’s over-all break-even point in dollar sales?

IIM K - Cost and Management Accounting 96

• 1. What is the company’s over-all break-even point in dollar sales?
Velcro Metal Nylon Total
Sales 1,65,000 3,00,000 3,40,000 8,05,000
Variable expenses 1,25,000 1,40,000 1,00,000 3,65,000
Contribution margin 40,000 1,60,000 2,40,000 4,40,000
Fixed expenses 4,00,000
Net operating income 40,000

• Break-even sales = Fixed cost/ CM ratio = 400,000/ (440,000/805,000) = 732,000

IIM K - Cost and Management Accounting 97

• 2. Of the total fixed expenses of $400,000, $20,000 could be avoided if the Velcro
product is dropped, $80,000 if the Metal product is dropped, and $60,000 if the Nylon
product is dropped. The remaining fixed expenses of $240,000 consist of common
fixed expenses such as administrative salaries and rent on the factory building that
could be avoided only by going out of business entirely.

• What is the break-even point in unit sales for each product?

IIM K - Cost and Management Accounting 98

 Velcro Metal Nylon
Unit selling price 1.65 1.5 0.85
Variable cost per unit 1.25 0.7 0.25
Unit contribution margin (a) 0.4 0.8 0.6
Product fixed expenses (b) 20,000 80,000 60,000
Unit sales to break even (b) ÷ (a) 50,000 1,00,000 1,00,000

• Break-even sales = Fixed cost/ CM ratio = 400,000/ (440,000/805,000) = 732,000

IIM K - Cost and Management Accounting 99

Practise question 3

• The Shirt Works sells a large variety of tee shirts and sweatshirts. Steve Hooper, the owner, is
thinking of expanding his sales by hiring high school students, on a commission basis, to sell
sweatshirts bearing the name and mascot of the local high school. These sweatshirts would
have to be ordered from the manufacturer six weeks in advance, and they could not be
returned because of the unique printing required. The sweatshirts would cost Hooper $8 each
with a minimum order of 75 sweatshirts. Any additional sweatshirts would have to be ordered
in increments of 75. Since Hooper’s plan would not require any additional facilities, the only
costs associated with the project would be the costs of the sweatshirts and the costs of the
sales commissions. The selling price of the sweatshirts would be $13.50 each. Hooper would
pay the students a commission of $1.50 for each shirt sold.

IIM K - Cost and Management Accounting 100

Part 1

1. What level of unit sales and dollar sales is needed to attain a target profit of $1,200?

IIM K - Cost and Management Accounting 101

Part 1

Selling price 13.5

Variable expenses:
Purchase cost of the sweatshirts 8
Commission to the student salespersons 1.5 9.5
Contribution margin 4

Since there are no fixed costs, the number of unit sales needed to yield the desired
$1,200 in profits can be obtained by dividing the target $1,200 profit by the unit
contribution margin:
Break-even point = Target profit/ Unit CM = 1200/4 = 300 units
Break-even revenues = 300 * 13.5 = $ 4,050

IIM K - Cost and Management Accounting 102

Part 2

• 2. Assume that Hooper places an initial order for 75 sweatshirts. What is his break-
even point in unit sales and dollar sales?

IIM K - Cost and Management Accounting 103

Part 2

Fixed cost = 75 shirts * 8 = 600

Variable cost (commission only) = 1.5

Contribution margin = selling price – variable expenses = 13.5 – 1.5 = 12

Break even point = fixed cost/ CM per unit = 600/ 12 = 50 units

Break-even sales = 50 * 13.5 = $ 675

IIM K - Cost and Management Accounting 104

THANKS

105