Session-16

 Cost-Volume-Profit (CVP) Relationship: An analytical

tool for management decision making.

14-11-2022
 Some facts
2

 What are the top line and bottom line of the

company?
 Cost structure of the company- Variable cost and
Fixed cost.
 Financial structure
 Capital Structure

14-11-2022
 Overview of Absorption
and Variable Costing
3

Absorption Variable
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Period
Period Variable Selling and Administrative Expenses
Costs
Costs Fixed Selling and Administrative Expenses

14-11-2022
 Variable Costing and CVP
4

 Variable costing
 Separates costs into fixed and variable components
 Shows fixed costs in lump-sum amounts, not on a per-
unit basis
 Does not allow for deferral/release of fixed costs
from/to inventory when production and sales volumes
differ

14-11-2022
 Analyst’s point
5

A manager wants to know how changes in firm’s

activity level affect bottom line (profitability) subject
to a given cost structure.

14-11-2022
 Analyst’s Point
6

How PROFIT is affected by the following five factor:

1. Selling prices
2. Sales volume
3. Unit variable costs
4. Total fixed costs
5. Mix of products sold.

Cost-Volume-Profit (CVP Relationship)

14-11-2022
 Key Assumptions of CVP Analysis
7

1. Company is operating within the relevant range

2. Revenue per unit remains constant-Selling price per unit is
constant.
3. Variable costs per unit remain constant
4. Total fixed costs remain constant
5. Costs are linear and can be accurately divided into variable
(constant per unit) and fixed (constant in total) elements.
6. In multiproduct companies, the sales mix is constant.
7. In manufacturing companies, inventories do not change (units
produced = units sold).

14-11-2022
 Part-I: Basics of Cost-Volume-Profit Analysis
8

The contribution income statement is helpful to

managers in judging the impact on profits of changes
in selling price, cost, and volume. The emphasis is on
cost behavior.
Racing Bicycle Company
Racing Bicycle Company Contribution Income Statement
SP per unit = $500
For the Month of June
VC per unit= $300
Sales (500 bicycles) $ 250,000
TFC=$ 80,000
Less: Variable expenses 150,000
Contribution margin 100,000
Less: Fixed expenses 80,000
Net operating income $ 20,000

Contribution Margin (CM) is the amount remaining from sales revenue after
variable expenses have been deducted.
14-11-2022
 Contribution
9

Sales (SP per unit × Q)

- Variable cost (VC per unit × Q)
= Total Contribution (or Contribution per unit × Q)
- Fixed cost
= Profit

Note:
1. Where, Q is the quantity sold.
2. New income statement format- called contribution format- in which
costs are organized by behaviors rather than by the traditional function
of production, sales, and administration.

14-11-2022
 Contribution
10

 Under marginal costing the term profit is not given

much importance but contribution is given more
weightage.
 Contribution is the useful guide towards profitability
in business. Hence it is the basis for business
decisions i.e.
A. Choosing a profitable product mix,
B. Optimal use of resources,
C. Make or buy decision, and
D. Profit planning.
14-11-2022
 Implication
11

A. CM is used first to cover fixed expenses. Any

remaining CM contributes to net operating income.
B. Contribution approach resulting from marginal
cost system enables one to calculate the profit at
various level of activity accurately. (Refer
Example-1).

14-11-2022
 Example1
12

The installed capacity of the company is 15000 uits.

On the basis of normal capacity of 10,000 units the
cost sheet showing per unit figures are as follows:
Materials 11.0
Labor 8.00
Overhead- Variable 3.00
- Fixed 6.00
------
28.00
Profit 02.00
-------
Selling Price 30.00
14-11-2022
 Analysis
13

 If production and sales is 10,000 units then profit

will be 10000*2= Rs.20,000.
 If production and sales is 8,000 units then profit will
not be 8000*2= Rs.16,000.
 At 8000 units the profit is Rs.4,000, because total
fixed cost is Rs.60,000.
Contribution= S-V=30-22=Rs.8
Total contribution= 8,000*8= Rs.64,000
Total fixed Cost = Rs. 60,000
Profit= Cont-FC= Rs.4,000 14-11-2022
 An Implication
14

 Thus the contribution approach , resulting from the

marginal cost system, enables one to calculate the
profit at various levels of activity accurately.
 In absorption costing – the practice of charging all costs (both
variable and fixed) to operations, processes or products. In
absorption costing system fixed overheads are also allotted to
cost units.
 Marginal costing- Only variable costs are charged to operations,
processes or products, while fixed costs are written off against
profits.
Refer the PPTs on Absorption costing Vs. Marginal Costing
14-11-2022
 Features of MC
15

1. Usefulness depends on identification of costs which

varies/changes in output.
2. In production only MC are taken into account.
3. Values of stocks of finished products and work in
progress are also calculated only on variable
cost.
4. Profitability of the departments or products is
determined in terms of contribution.

14-11-2022
 Contribution Margin Ratio (CMR)
16

A. The CM ratio is calculated by dividing the total contribution

margin by total sales.
B. Use the contribution margin ratio (CMR) to compute changes
in contribution margin and net operating income resulting
from changes in sales volume.
C. Also called as Profit-Volume Ratio (P/V) ratio) or ,
marginal income ratio.

14-11-2022
 Contribution Margin Ratio (CM Ratio)
17

The CM ratio is calculated by dividing the total

contribution margin by total sales.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit CM Ratio
Sales (500 bicycles) $ 250,000 $ 500 100%
Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 $ 200 40%
Less: Fixed expenses 80,000
Net operating income $ 20,000

($100,000 / $250,000)× 100 = 40%

14-11-2022
 Contribution Margin Ratio (CM Ratio)
18

If Racing Bicycle increases sales by $50,000, contribution

margin will increase by $20,000 ($50,000 × 40%).
Here is the proof:
400 Units 500 Units
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income $ - $ 20,000

A $50,000 increase in sales revenue results in a $20,000

increase in CM. ($50,000 × 40% = $20,000)
14-11-2022
 Contribution Margin Ratio (CM Ratio)
19

The relationship between profit and the CM ratio can be

expressed using the following equation:

Profit = CM ratio × Sales – Fixed expenses

If Racing Bicycle increased its sales volume to 500
bikes, what would management expect profit or net
operating income to be?

Profit = 40% × $250,000 – $80,000

Profit = $100,000 – $80,000
Profit = $20,000
14-11-2022
 Analyst’s Point
20

• P/V ratio (normally a percentage) is the rate at

which contribution or profit increases with
volume.
• P/V ratio is constant for a single unit of product
or a number of units. It remains constant over
substantial changes of volume.

14-11-2022
 Interpretation
21

A. A high P/V ratio indicates that a slight increase in

volume (without increase in fixed cost) would give
higher profit.
B. P/V also indicate that the profitability can be
improved if the management concentrate on the
manufacture of products having high P/V ratio.
C. This ratio is not affected by any change in fixed
overhead, although the change in fixed cost will
affect profit.

14-11-2022
 Analyst’s point (CVP analysis)
22

1. Sales, variable expenses, and contribution margin can also be

expressed on a per unit basis.
2. We do not need to prepare an income statement to estimate
profits at a particular sales volume. Simply multiply the
number of units sold above break-even by the contribution
margin per unit.
3. Changes in Sales: If Racing Bicycle increases sales by
$50,000 above break even sales, contribution margin will
increase by $20,000 ($50,000 × 40%).
4. Changes in Fixed Costs and Sales Volume: What is the profit
impact if Racing Bicycle can increase unit sales from 500 to
540 by increasing the monthly advertising budget by
$10,000? 14-11-2022
 Analyst’s point (CVP analysis)
23

5. Change in Variable Costs and Sales Volume: What is the profit

impact if Racing Bicycle can use higher quality raw materials, thus
increasing variable costs per unit by $10, to generate an
increase in unit sales from 500 to 580?
Sales increase by $40,000, and net
operating income increases by $10,200

14-11-2022
 Case point
24

6. If RBC has an opportunity to sell 150 bicycle

to a wholesaler without disturbing sales to other
customers or fixed expenses, what price would it
quote to the wholesaler if it wants to increase
monthly profits by $3,000?

14-11-2022
 Change in Regular Sales Price
25

$ 3,000 ÷ 150 bikes = $ 20 per bike

Variable cost per bike = 300 per bike
Selling price required = $ 320 per bike

150 bikes × $320 per bike = $ 48,000

Total variable costs = 45,000
Increase in net operating income = $ 3,000

14-11-2022
 Implication
26

7. Change in Fixed Cost, Sales Price and Volume: What is the

profit impact if RBC: (1) cuts its selling price $20 per unit, (2)
increases its advertising budget by $15,000 per month, and (3)
increases sales from 500 to 650 units per month?

14-11-2022
 Example-2
27

A company sold in two successive periods 7000 and

9000 units respectively and incurred a loss of
Rs.10,000 and earned a profit of Rs.10,000 in the
two periods respectively. Sells price per unit is
Rs.100. Calculate:
1. Amount of fixed expenses
2. Number of units to breakeven
3. Number of units to earn a profit of Rs.40,000.

14-11-2022
 Part II. Break Even Point (BEP)
28

 The quantity of output where there would be neither

loss nor profit.
Refer the computation

14-11-2022
 Factors which can change BEP
29

A. Change in Fixed cost

B. Change in variable cost
C. Change in selling price per unit
D. Change in production quantity beyond present
capacity limit.

Note: if production exceeds capacity the fixed cost

will increase, which ultimately affect the BEP.

14-11-2022
 Calculation of BEP from total sales
30

Following information:
Total sales = Rs.20,00,000
Variable Expenses = 11,00,000
Net profit = 2,25,000
________________________________________
1. Estimate variable cost to sales ratio= 55%
2. 1-(V/S) = contribution/sales = 45%
3. The ratio of Contribution/Sales is also called as
P/V ratio.
4. BEP = ? 14-11-2022
 Part III: Margin of safety (MOS)
31

• One indicator of risk, the Margin of Safety (MOS) measures the distance
between budgeted sales and breakeven sales:
MOS = Budgeted Sales – (Break Even) Sales
 The amount by which sales can drop before losses begin to be incurred.

• The MOS Ratio removes the firm’s size from the output, and expresses itself
in the form of a percentage:
MOS Ratio = MOS ÷ Budgeted Sales

 MS = Profit/PV ratio
 MS (units) = Profit/contribution per unit
14-11-2022
 Margin of Safety
32

 How far the company is operating from its BEP

 Budgeted (or actual) sales after the BEP
 The amount that sales can drop before reaching the BEP
 Measure of the amount of “cushion” against losses
 Indication of risk
 The lower the margin of safety, the more carefully
management must watch sales and control costs.

14-11-2022
 Margin of Safety
33

 Units
Actual units — break-even units
 Dollars
Actual sales dollars — break-even sales dollars
 Percentage
Margin of Safety in units or dollars
Actual unit sales or dollar sales

14-11-2022
 Interpretation
34

 Once break even sales amount is achieved

contribution from additional sales (MS) generates
profit only.
 Improvement of MS:
 Lowering fixed cost
 Lowering VC
 Increasing sales volume if there is capacity
 Increasing selling price if market permits
 Changing the product mix so as to increase total
contribution.

14-11-2022
 Interpretation
35

 A high MS makes a business less vulnerable to a

decline in sales volume, in such a case the BEP is
much below the actual sales and in case there is
fall in sales still there will be some profit.

14-11-2022
 Part-B: Cost Structure
36

1. Variable cost
2. Fixed cost: A cost which tends to be unaffected by
variations in volume of output . Fixed cost depend
mainly on the effluxion of time and do not vary
directly with volume or rate of output. Fixed costs are
some times referred as period cost. There may
different levels of fixed costs at different levels of
output.
3. Semi-variable or semi-fixed cost- partly fixed and
partly variable.
Note: the relative proportions of each type of cost in an
organization is known as its cost structure.
14-11-2022
 1: Variable Cost
37

 Varies in direct proportion to changes in level

of activity and is constant per unit.

14-11-2022
 Activity base
38

 Activity base: for a cost to be variable, it must be

variable with respect to “something”- is its activity
base. An activity base is a measure of whatever
causes the incurrence of variable cost (some times
called as cost drivers). Example: direct labor hours,
machine hours, unit produced and sold.

14-11-2022
 Analyst’s point
39

 People sometimes get the notion that if a cost

doesn’t vary with production or with sales, then it is
not a variable cost.
 Example: Analyzing the cost of service calls under a
product warranty. The relevant activity measure is
the number of service calls made. Those costs that
vary in total with the number of service calls made
are the variable costs of making service calls.

14-11-2022
 2: Fixed costs
40

Referred as capacity costs. For planning purposes fixed costs can

be either committed or discretionary.
A. Committed Fixed costs: depreciation of building, equipment,
real estate tax, insurance expenses, salaries of top management
and operating personnel.
 Once a decision is made to acquire committed fixed resources,

the company may be locked into that decision for many years
to come. Consequently such commitments should be made only
after careful analysis of the available alternatives.

14-11-2022
 Fixed cost
41

B. Discretionary fixed costs: Often referred as managed fixed costs

usually arise from annual decisions by management to spend on certain
fixed cost items. Example: Advertising, Research, Public relation,
management development programs and internships for students.
 Whether a particular cost is regarded as committed or discretionary

may depend on management’s strategy. For example, some

construction companies may layoff workers during months with minimal
customer demand. However, other construction companies may opt to
retain their workers all year.
 The most important characteristics of discretionary fixed costs is that

management is not locked into its decisions regarding such costs.

Discretionary costs can be adjusted from year to year or even perhaps
during the course of a year if necessary. 14-11-2022
 Analyst’s point
42

The trend in many industries is toward greater

fixed costs relative to variable costs.

As machines take over Knowledge workers

many mundane tasks tend to be salaried,
previously performed highly-trained and
by humans, difficult to replace. The
“knowledge workers” cost of compensating
are demanded for these valued employees
their minds rather is relatively fixed
than their muscles. rather than variable.
14-11-2022
 Is Labor a Variable or a Fixed Cost?
43

The behavior of wage and salary costs can differ across countries,
depending on labor regulations, labor contracts, and custom.

In France, Germany, China, and Japan, management has

little flexibility in adjusting the size of the labor force.
Labor costs are more fixed in nature.

In the United States and the United Kingdom, management

has greater latitude. Labor costs are more variable in nature.

Within countries managers can view labor costs differently

depending upon their strategy. Most companies in the
United States continue to view direct labor as a variable cost.
14-11-2022
 Quick Check 
44

Which of the following statements about cost behavior are

true?
a. Fixed costs per unit vary with the level of activity.
b. Variable costs per unit are constant within the relevant
range.
c. Total fixed costs are constant within the relevant range.
d. Total variable costs are constant within the relevant
range.

14-11-2022
 Quick Check 
45

Which of the following statements about cost behavior

are true?
a. Fixed costs per unit vary with the level of activity.
b. Variable costs per unit are constant within the relevant
range.
c. Total fixed costs are constant within the relevant
range.
d. Total variable costs are constant within the relevant
range.

14-11-2022
 3. Mixed Costs
46

 Mixed costs (also called semi-variable or semi-fixed costs).

Contain both variable and fixed cost elements.
 Example: Costs of providing X-ray services to patients at
Apollo Hospital is a mixed case. The cost of depreciation and
radiologists and technician’s salaries are fixed but cost of X-
ray film, power, and supplies are variable.
 At Indian Airlines maintenance costs are a mixed cost. Rent
for maintenance facility, mechanics on pay roll are fixed costs
but costs of replacement parts, lubricating oil, tires are
variable cost with respect to how often and how far the
aircraft flown.

14-11-2022
 Segregation of semi-variable overheads
47

a) Level of activity method

b) Range method
c) Degree of variability method
d) Scatter graph method
e) Least square method

14-11-2022
 a. Level of activity method
48

 The outputs of two different levels are compared.

Variable overheads are calculated as:
Variable Expenses per unit = (Change in amount of
expenses)/(Change in
activity or quantity)

Note: Hence variable expenses per unit is the ratio of

change in expenses/change in output.
14-11-2022
 Example-3
49

Months Production units Semi-variable expenses

January 60 130
February 40 110
March 70 150
April 120 210

14-11-2022
 b. Range Method
50

 Range method is similar to level of activity method,

but in range method the highest and lowest activity
levels are taken into consideration to calculate the
ratio.

14-11-2022
 c. Degree of variability method
51

 Degree of variability is noted or identified for

each item of semi-variable expenses.
 Least applicable-identification of variability
percentage is not easy. i.e. it may be assumed that
the degree of variability is 60% of the total
expenses (semi variable overheads).
 Example: variable expenses for April=
210*.60=126. hence FC= 210-126=84

14-11-2022
 d. Least Square method

52

xy
Variable component per unit =
x

2

X= deviation of units /quantity from its average = x-mean x (x for units)

Y = Deviation of overheads (semi-variable ) from its average. = y-mean y (y for semi-
variable expenses)

Fixed cost = Average cost – VC per unit * average number of units

Refer Example- 4
14-11-2022
 Example
53

Months Production Units (X) Semi-variable expenses –

Y-(Rs)
January 60 130
February 40 110
March 70 150
April 120 210
May 90 170
June 130 245
Total  x = 510  y = 1015

X= Independent variable and Y= dependent variable

14-11-2022
 54

SOME SPECIAL CASES

14-11-2022 Application of BEP
 A: Cash Break-Even Point
55

 In the computation of cash BEP only cash fixed costs

are considered. Cash fixed costs exclude
depreciation and other non-cash fixed expenses. BY
cash BEP we can ascertain that level of output or
sales revenue will be equal to net cash inflow.

 Cash BEP = Cash fixed cost/Contribution per unit.

14-11-2022
 B: Composite Break even (C-BEP)
56

 C-BEP is calculated taking into consideration the

data related to all products together, where more
than one product are manufactured by a firm.
 For this calculation the total fixed cost is divided by
composite P/V ratio. Composite P/V ratio is
calculated by dividing total contribution (of all
products) by total sales (of all products) and
multiplied by 100.
 Composite contribution per unit can be calculated
by adding contribution from various products in the
proportions of their product mix.
14-11-2022
 Example-5
57

 A company manufactures and sells four products. The sales mix

in value comprises of 33.33%, 41.67%, 16.67%, and 8.33%
of A B C and D respectively. The total budgeted sales (100%)
are Rs.60,000 per month. Operating or variable costs are as
follows:
A= 60% of sales, B=68% of sales, C=80% of sales, and D=
40% of sales.
Total FC are Rs.14,700 per month. Calculate BEP for the
enterprise as a whole.

Refer another example CVP-1

14-11-2022
 C: Cost Break even (C-BEP)
58

 Cost BEP is that level of activity at which the cost

(operating) in two alternative plants are equal.
 Normally, two plants producing similar products may
have different fixed and variable costs per unit.
 It is desired to determine that point at which total cost
(Fixed+ variable) of operating both the plants are
equal. This plant is known as Cost Break Even Plant,
calculated as:
 Cost BEP = Differences in FC/Differences in VC per unit.
14-11-2022
 Implication
59

 Cost BEP is useful to identify which plant is more

profitable for a given level of output (according to
high and low demand).
 In other words, both plants will be equal at the cost
break even point but if activity level goes up , the
plant will be more profitable which has lower VC
per unit or higher contribution per unit.
 It will also be observed that if activity level is less
than C-BEP, that plant which has lower FC will be
more profitable.
14-11-2022
 Example-5A
60

 There were two plants A and B operating in a firm.

Their FC were Rs.3,00,000 and 4,50,000
respectively. The VC per unit of plant A is Rs.6 and
that of plant B is Rs.5. Find out cost BEP for plant A
and B. Also show the financial implication when
demand is 1,00,000 units and 2,00,000 units.

14-11-2022
 D: Break even of Merged plants
61

 When two or more plants of a firm are merged,

there is need of calculating break even point of the
merged plant.
 The BEP of the merged plants will be calculated on
the basis of sales and cost figures of different
plants at their 100% capacity level.
 Thus sales and cost data of all plants will be
calculated at 100% capacity level, thereafter BEP
will be ascertained on the basis of totals of sales
and costs of all plants taken together.
14-11-2022
 Example-6
62

A, B and C are three similar plants under the same

management which wants to merge for better
operation. The results are as under:
Plant A B C
Capacity operated 100% 70% 50%
Turnover (Rs. In Lakhs) 300 280 150
Variable cost (Rs. In Lakhs) 200 210 75
Fixed cost (Rs. In lakhs) 70 50 62
Find out (a) capacity of the merged plant at break even (b) profit
at 75% capacity of the merged plant (c ) turnover from the
merged plant to give a profit of Rs.28 lakhs.
14-11-2022
 E: Key Factor Or Limiting Factor
63

 With the objective of profit maximization, those

products which yield highest contribution are sold in
maximum quantities.
 In this case it is assumed that there will be no
limitation which may create restriction in increasing
quantities of one or more products.
 In practice there may be number of factors which
may create limitations. These may be shortage of
material, labor, plant capacity or sales.

14-11-2022
 Key Factor Or Limiting Factor
64

 If materials are available in limited quantity , the

selection of profitable product will be on the basis
of contribution per unit of material.
 Note: when sales is the key factor, the profitability
of a product is measured by P/V ratio.
 Thus where a business produces a variety of
products, the objective should be to produce and
sell a mix of products which gives the greatest
contribution per unit of limiting factor or key factor.

14-11-2022
 F: CVP and Income Taxes
65

• From time to time it is necessary to move back and forth

between pre-tax profit (OI) and after-tax profit (NI),
depending on the facts presented
• After-tax profit can be calculated by:
OI x (1-Tax Rate) = NI
• NI can substitute into the profit planning equation through this
form:
OI =

14-11-2022
 Desired Profit and Tax
66

Treatment of desired profit before tax:

Desired sales units = (FC+ PBT)/Contribution margin
per unit
Desired sales revenue = (FC+PBT)/(P/v ratio)
The amount of desired profit can be mentioned as a
profit after income tax. In such case, the PBT is
calculated as:
PBT = PAT/ (1-tax rate)

14-11-2022
 Income Statement Proof
67

Sales $ 240,000 (20,000 * 12)

Less Total variable costs (80,000) (20,000 * 4)
Contribution Margin $ 160,000
Less Total fixed costs (100,000)
Profit before taxes $ 60,000
Income taxes (12,000) (60,000 * 20%)
Profit after taxes $ 48,000

If fixed costs are $100,000, unit sales price is $12,

unit variable cost is $4, and the desired after-tax
profit is $48,000, the required sales are $240,000.
14-11-2022
 Using CVP Analysis

Set profit per unit

X = FC/(CMu - PuBT)

Profit
per Unit
Sales Before Tax
Total Contribution
Volume
Fixed Margin
Cost

68 14-11-2022
 Operating Leverage
69

 Relationship of variable and fixed costs

 Effect on profits when volume changes
 Cost structure strongly influences the impact that a
change in volume has on profits

14-11-2022
 Operating Leverage
70

High Operating Leverage Low Operating Leverage

 Low variable costs  High variable costs

 High fixed costs  Low fixed costs

 High contribution margin  Low contribution margin

 High BEP  Low BEP

 Sales after break-even have  Sales after break-even have

greater impact on profits lesser impact on profits

14-11-2022
 Degree of Operating Leverage
71

 Measures how a percentage change in sales will

affect profits
 Degree of Operating Leverage
Contribution Margin
Profit Before Taxes

14-11-2022
 Degree of Operating Leverage
and Margin of Safety

 When margin of safety is small, the degree

of operating leverage is large

Margin of Safety % = 1/Degree of Operating Leverage

Degree of Operating Leverage = 1/Margin of Safety %

72 14-11-2022
 Degree of Operating Leverage
and Margin of Safety

Actual sales 200,000 units

Break-even sales 90,000 units
Contribution margin $408,000
Profit before tax $224,400

Margin of Safety % = Actual sales – Break-even sales

Actual sales

55% = 200,000 – 90,000

200,000

73 14-11-2022
 Degree of Operating Leverage
and Margin of Safety

Actual sales 200,000 units

Break-even sales 90,000 units
Contribution margin $408,000
Profit before tax $224,400

Degree of Operating = Contribution margin

Leverage = Profit before taxes

1.818 = $408,000
$224,400

74 14-11-2022
 Degree of Operating Leverage
and Margin of Safety

Margin of Safety % = 1
Degree of Operating Leverage
55% = 1
1.818

Degree of Operating = 1
Leverage Margin of Safety%
1.818 = 1
.55
75 14-11-2022
 Analyst’s point
76

1. Relationship between VC and FC is reflected in its operating

leverage.
2. Highly labor intensive firms- high VC , low FC- have low OL.
3. Highly capital intensive firms- high FC , low VC- have high OL.
4. DOL decreases as sales move upward from BEP
5. Thus when MS is low, the DOL is high. In point at BEP the DOL
is infinite.

14-11-2022
 G: Operating leverage (OL)
77

• Operating Leverage (OL) is the effect that fixed costs have on

changes in operating income as changes occur in units sold,
expressed as changes in contribution margin
OL = Contribution Margin ÷ Operating Income
• Notice these two items are identical, except for fixed costs
 OL is a measure of the effect of a percentage change in sales on

PBT.OL can help management with relatively large P/V ratio and
larger fixed cost to increase the net income with a small increase in
sales volume.
 OL = Contribution margin/PBT.

 Note: since the difference between contribution and Profit is fixed

cost, companies with large amount of FC will generally have a

high OL. A high OL indicates that a small increase in sales will give
14-11-2022
a large percentage increase in net income.
 Sensitivity Analysis
78

• CVP Provides structure to answer a variety of “what-if”

scenarios.
• “What” happens to profit “if”:
A. Selling price changes
B. Volume changes
C. Cost structure changes
D. Variable cost per unit changes
E. Fixed cost changes

14-11-2022