Question

Cost, volume, profit analysis identifies a transaction’s “contribution’ to fixed costs. Explain the meaning of ‘contribution’ and discuss the usefulness of such analysis in making business decisions. (limit 120 words)

Answer 1

Contribution Margin
Contribution margin is an important concept in CVP analysis. It represents the amount of revenues minus variable costs available to recover fixed costs. Once the fixed costs have been recovered, further increases in the contribution margin from increased sales volume flow straight to operating income.
CVP analysis is based on the assumption that there are two kinds of costs in producing a product: fixed and variable.
• Fixed costs do not change in total. As long as the activity remains within the relevant range, the level of production or sales has no effect on fixed costs.
• Variable costs are costs per unit of production. Variable costs change in total in response to fluctuations in the level of production or sales.
The difference between an item’s selling price and the variable costs to produce and sell it is the amount that goes toward covering a company’s fixed costs. The difference between the selling price of a unit and its variable cost is the unit contribution margin (or simply contribution) and is calculated as follows:
Unit Contribution Margin = Selling Price per Unit – Variable Costs per Unit

The total contribution margin can be calculated in two ways:
1) Total Contribution Margin = Unit Contribution Margin × Number of Units Sold

Or
2) Total Contribution Margin = Total Revenue – Total Variable Costs

Cost-Volume-Profit (CVP) Analysis

Cost-volume-profit analysis (CVP), also known as breakeven analysis, is used primarily for short-run decision-making. In the short run, the market usually determines the prices and costs of a company’s products. Generally speaking, the market governs prices, chiefly through the prices consumers are willing to pay and through actions of competitors. Furthermore, costs can be reduced to a certain degree by seeking cost concessions from suppliers and by value engineering.1 Otherwise, the only things the company can control are the products it makes and the quantities it produces and sells—in other words, the supply of the product.
Companies use CVP analysis to determine which products they will supply and the amount they will supply at a given price and cost. Since prices and costs are reasonably fixed in the short run, the profitability of a product depends most upon the quantity sold. Therefore, CVP analysis is used to calculate the effect on profitability caused by changes in product mix and in quantities sold.
CVP analysis enables a company to find the level of production and sales, both in units and in revenue, required for the company to break even. It may also be used to determine the level of production and sales necessary to achieve a specific profit level. In short, CVP analysis examines the relationship among revenue, costs, and profits.
In order to use CVP analysis, a number of assumptions need to be made. These assumptions simplify the many variables in the real world:
• All costs are either variable or fixed costs. The presumption is that there are no mixed (that is, semi-variable or semi-fixed2) costs.
• Total costs and total revenues are predictable and linear in relation to output units within the relevant range and time period. Changes in the level of revenues and total costs arise only because of changes in the number of units produced and sold.
• Fixed costs remain constant over the relevant range. Fixed costs include both direct fixed costs and indirect (allocated) fixed costs.
• Unit variable costs remain constant over the relevant range. Total variable costs change in proportion to activity level because the cost per unit remains constant. Variable costs include both direct variable costs and indirect (allocated) variable costs.
• The unit selling price remains constant over the relevant range, and the sales mix remains constant as the level of total units sold changes.
• Finished goods and work-in-process inventory do not change significantly (that is, production equals sales).
• The time value of money is ignored.