Question

a. How are contribution margin and break even related?

b. What happens to break even point if variable cost per unit changes, if fixed cost changes?

c. Explain the degree of operating leverage and how it is related to a companies profit risk.

Answer 1

Answer a) The contribution margin and break even points are related to each other. Both are tools of marginal costing and their calculation is interlinked. In order to calculate break-even point inn sales unit, fixed cost expenses of the company should be divided by the contribution margin ratio. One similarity between contribution margin and breakeven point is that in order to calculate both, company revenue or net sales and variable cost is required.

Formula for contribution margin = Net sales – variable cost

Formula for breakeven point = Fixed expenses / contribution margin ratio

Answer b) The breakeven point is directly related with fixed cost. With the increase in the fixed cost breakeven point will increase and with the decrease in the fixed cost, breakeven point will decrease.

If the variable cost decreases, it will increase contribution margin, and will reduce the breakeven point. Let’s take the example, suppose fixed cost = $30000, Selling price per unit = $12 per unit, Variable cost = $5 per unit

Breakeven point = $30000/ $12-$5

= $30000 / $7

= 4286 units (approximately)

If variable cost is reduced to $3 and rest remains the same

Breakeven point = $30000 / $12-$3

= $30000 / $9

= 3333 units (approximately)

Answer c) Degree of the operating leverage is the method used to measure the companies operating risk. The risk is due to the existence of fixed and variable cost. Low degree of operating risk indicates that the company has high variable cost as compared to its fixed cost which means significant increase in the sales will not increase its operating income, and due to low operating income there is risk that company may not fulfill its high fixed cost. Degree of operating income can be calculated using the formula

Degree of operating income = percentage change in operating income / percentage change in sales

Or

Degree of operating income = contribution margin / operating income