Fixed costs are said to be costs that are output independent. Fixed costs remain constant with the activity changes. An example is rent. For instance, if a cement manufacturing firm rents a building, it must pay the rent regardless no cement is being manufactured every month. Variable costs change with the activity changes (Rumble, 2012). Such variable costs increase relative to both capital and labor. For example, utilities, wages and direct material costs. Mixed costs are also known as semi-variable costs. These costs can have features of both fixed and variable costs. For example, electricity. Usage of electricity may rise with the production but also if no production is done, a firm still needs some amount of power to ensure maintenance. Relevant range is described as the particular activity level that happens to be between the maximum and the minimum amount. Relevant range is also the activity within which any firm is expected to operate. The relevant range is considered an assumption towards particular costs as being variable or fixed.
Contribution margin is the revenue from sales amount that is greater than the variable costs. It is considered the net amount contributed by sales. Contribution margin is calculated as follows:
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CM = S – TVC where “CM is the contribution margin, S is the total sales and TVC is the total variable costs.”
The equation approach is used to determine the profits of any firm. To calculate the firm’s profits using the equation method is: (“Profits= Sales – Variable expenses – Fixed expenses”). The contribution approach is used in the income statement presentation where all the aggregates are done for the variable costs then deducted from the company’s revenue to get the contribution margin. Then the contribution margin deducts the fixed costs to obtain the net loss or profit. The contribution margin approach is used in the break-even point calculations. Contribution margin is defined as the difference between variable costs and sales. The break-even point is calculated as:
“ Break-even sales = x = FC ÷ (p − v) where x is the total number of units, p is unit price, v is the unit variable cost and FC is the fixed cost.”
CVP Chart Presentation
The four step process in creation of the CVP chart are as follows:
i) Selecting the sales volume and doing the total sales revenue plots
ii) Illustrating the fixed cost line
iii) Illustrating the total cost line
iv) Identifying the operating income and loss areas and the break-even point.
Fig 1: CVP Chart Presentation (Source: https://www.myaccountingcourse.com/accounting-dictionary/cost-volume-profit-chart)
Margin of safety is described as the excess that arises from the total sales over the sales volume of the break-even point. The margin of safety asserts that the sales amount can reduce before the losses happen in a company. The margin of safety is calculated as the total sales less the sales of the break-even point. Operating leverage is an expression that measures the firm’s degree in causing a rise in the operating income through the increase in the firm’s revenue (Kahl, Lunn & Nilsson, 2019). Any business that generates increased sales with increased gross margin and reduced variable costs is said to have increased operating leverage.
References
Kahl, M., Lunn, J., & Nilsson, M. (2019, May). Operating leverage and corporate financial policies. In AFA 2012 Chicago Meetings Paper.
Rumble, G. (2012). The costs and economics of open and distance learning. Routledge.
xplaind.com/943650/break-even-point-contribution-approach
xplaind.com/325438/contribution-margin
www.accountingtools.com/articles/what-is-the-contribution-approach.html
www.myaccountingcourse.com/accounting-dictionary/cost-volume-profit-chart
