TABLE OF CONTENTS Learning objectives
After studying this chapter, you should have developed an appreciation of:
What is meant by contribution margin and contribution margin ratio
The benefits that derive from using the contribution margin format when preparing a profit and loss statement
How breakeven can be determined
How the level of sales required to achieve a before- or after- tax target profit can be determined.
When considering a decision to enter a new commercial activity (e.g. open a restaurant), questions frequently posed by managers include: How many units will we need to sell in order to break even? and How much will we need to sell in order to achieve our target profit level? Other questions that sometimes arise in connection with existing activities include: What will happen to profit if we manage to increase sales volume by 10%? and If we increase advertising by 15%, how much more would we have to sell in order to maintain our current level of profit? This chapter outlines an analytical approach that will enable you to answer these types of questions. This approach is generally referred to as cost-volume-profit (CVP) analysis.
The primary focus in CVP analysis concerns projecting future levels of profitability. Projecting profit requires an understanding of how much costs and profits will fluctuate following a change in sales volume. The conventional profit and loss statement, such as that presented as Exhibit 7.1, is unfortunately not well designed to support such an analysis.
