Operating leverage is a measure of how sensitive net profit is to percentage changes in sales.
With high leverage, a small percentage increase in sales can produce a much larger percentage increase in net profit.
With a measure of operating leverage of 5, if a company increases its sales for example by 10%, net profit would increase by 50%.
What happens when a company has multiple products?
To calculate break-even divide total fixed costs by the contribution margin per unit. In order to use the single product mix method, managers must define a package or bundle of products and compute break-even or target volume for the package or bundle. Therefore need a weighted average contribution margin.
1.Calculate sales mix which is the relative proportions in which a company’s products are sold.
2.Calculate the weighted average contribution margin which is calculated as:
Weighted Average Contribution Margin
= contribution margin of a product x the percentage of the product in the product mix
3. Calculate the break even point of the mix
Assumptions and Limitations of CVP Analysis
CVP analysis is based on a number of simplistic assumptions about cost behavior which undermine the model’s effectiveness
1.Selling price is constant. The assumption is that the selling price of a product will not change as the unit volume changes. This is not wholly realistic since there is usually an inverse relationship between price and unit volume. In order to increase volume it is often necessary to drop the price. However, CVP analysis can easily accommodate more realistic assumptions.
2.Costs are linear and can be accurately divided into variable and fixed elements. It is assumed that the variable element is constant per unit and the fixed element is constant in total. This implies that operating conditions are stable and there are no major changes in worker efficiency. It also implies that the fixed costs are really fixed. When there are large changes in volume, this assumption becomes tenuous. However, if a manager is able to estimate the effects of a decision on fixed costs, these estimates can be explicitly taken into account in CVP analysis.
3.The sales mix is constant in multi-product companies. This assumption is invoked in order to use the simple break-even and target profit formulas in multi-product firms. If unit contribution margins are fairly uniform across products, violations of this assumption will not be important. However, if unit contribution margins differ a great deal, then changes in the sales mix can have a big impact on the overall contribution margin ratio and hence upon the results of CVP analysis. If a manager can predict how the sales mix will change, then a more refined CVP analysis can be performed in which the individual contribution margins of products are computed.
4.In manufacturing companies, stocks do not change. It is assumed that everything the company produces is sold in the same period. Violations of this assumption result in discrepancies between financial accounting profit and the profits calculated using the contribution approach.
Here is a summary of what we have talked about so far regarding Cost Volume Profit (CVP) / Break Even Analysis:
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