Understanding Business Accounting For Dummies, 2nd Edition (70 page)

Per-unit values

Fixed versus variable
operating expenses

Contribution margin
- total and per unit

Handle this information with care. The contribution margin per unit is confidential, for your eyes only. This information is limited to you and other managers in the business. Clearly, you don't want your competitors to find out your margins. Even within a business, the information may not circulate to all managers - just those who need to know.

The contribution margin per unit is one of the three most important determinants of profit performance, along with sales volume and fixed expenses - as shown in the upcoming sections.

With the information provided in the management profit and loss account, you're ready to paint a what-if scenario. We're making you the chief executive officer of the business in this example. What if you had sold 5 per cent fewer units during this period? In this example, that would mean you had sold only 494,000 units rather than 520,000 units, or 26,000 units less. The following computation shows you how much profit damage this seemingly modest drop in sales volume would've caused.

Impact of 5% Lower Sales Volume on Profit

Contribution margin per unit £32

× 26,000 fewer units sold
26,000

Equals: Decrease in earnings before tax £832,000

By selling 26,000 fewer units you missed out on the £832,000 profit that these units would have produced - this is fairly straightforward. What is not so obvious, however, is that this £832,000 decrease in profit would have been a 30 per cent drop in profit: (£832,000 decrease ÷ £2,800,000 profit = 30 per cent decrease). Lose just 5 per cent of your sales and lose 30 per cent of your profit? How can such a thing happen? The next section expands on how a seemingly small decrease in sales volume can cause a stunning decrease in profit. Read on.

Violent profit swings due to operating leverage

First, the bare facts for the business in the example: the company's contribution margin per unit is £32 and, before making any changes, the company sold 520,000 units during the year, which is 87,500 units in excess of its break-even sales volume. The company earned a total contribution margin of £16,640,000 (see Figure 9-2), which is its contribution per unit times its total units sold during the year. If the company had sold 5 per cent less during the year (26,000 fewer units), you'd expect its total contribution margin to decrease 5 per cent, and you'd be absolutely correct - £832,000 decrease ÷ £16,640,000 = 5 per cent decrease. Compared with its £2,800,000 profit before tax, however, the £832,000 drop in total contribution margin equals a
30 per cent
fall-off in profit.

The main focus of business managers and investors is on profit, which in this example is profit before tax. Therefore, the 30 per cent drop in profit would get more attention than the 5 per cent drop in total contribution margin. The much larger percentage change in profit caused by a relatively small change in sales volume is the effect of
operating leverage
. Leverage means that there is a multiplier effect - that a relatively small percentage change in one factor can cause a much larger change in another factor. A small push can cause a large movement - this is the idea of leverage.

In the above scenario for the 5 per cent, 26,000 units decrease in sales volume, note that the 5 per cent is based on the total 520,000 units sales volume of the business. But, if the 26,000 units decrease in sales volume is divided by the 87,500 units in excess of the company's break-even point - which are the units that generate profit for the business - the sales volume decrease equals 30 per cent. In other words, the business lost 30 per cent of its profit layer of sales volume and, thus, the company's profit would have dropped 30 per cent. This dramatic drop is caused by the operating leverage effect.

Note:
If the company had sold 5 per cent
more
units, with no increase in its fixed expenses, its pre-tax profit would have
increased
by 30 per cent, reflecting the operating leverage effect. The 26,000 additional units sold at a £32 contribution margin per unit would increase its total contribution margin by £832,000 and this increase would increase profit by 30 per cent. You can see why businesses are always trying to increase sales volume.

Cutting sales price, even a little, can gut profit

So, what effect would a 5 per cent decrease in the sales price have caused? Around a 30 per cent drop similar to the effect of a 5 per cent decrease in sales volume? Not quite. Check out the following computation for this 5 per cent sales price decrease scenario: