How to Select a Cost Structure for CVP

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  • 0:04 Cost Structure
  • 4:17 Operating Leverage
  • 5:16 Lesson Summary
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Lesson Transcript
Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology.

Companies incur costs to make a profit. Management must choose a cost combination that will maximize profit. In this lesson, you'll learn how to select a cost structure.

Cost Structure

Mr. U. Bright owns the Lamps 4 You company, which manufacturers lighting products. He recently examined his manufacturing costs and wants to determine how the purchase of a new piece of equipment would impact his costs. Let's examine how Mr. U. Bright could complete this analysis.

A company incurs different costs in order to manufacture its goods, and these costs can be classified as either variable costs or fixed costs. Variable costs are those costs that change with the amount of production activity. The amount of materials used and the amount of labor needed to manufacture items would be examples of variable costs. Fixed costs do not change with the level of production, such as the mortgage payment on Mr. U. Bright's production facility, which would be the same whether the company produced 10 or 10,000 lamps.

A company's cost structure refers to the combination of variable and fixed costs that it incurs. The amount of profit that a company generates is affected by its costs and the volume of production. This relationship is known as cost-volume-profit analysis, or CVP. When a company is selecting its cost structure, it would consider its appetite for risk, as some structures will be more risky than others.

Let's assume that Mr. U. Bright is trying to decide whether or not he should buy new equipment that incorporates the latest technology. This technology won't help him make the lamps any faster, but it will allow him to save money on direct labor (a variable cost), as fewer employees will be required on the production line. Even though Mr. U. Bright's variable costs will decrease, his fixed costs will go up, as more depreciation will be required on his new equipment. Depreciation, a fixed cost, represents the cost of using an asset, such as a piece of equipment, to earn revenue over its useful life.

The analysis shows that sales revenue and operating income remain the same under both alternatives. Since the variable costs would be lower if the equipment is purchased due to lower direct labor costs, the contribution margin is higher. Contribution margin represents the amount of money that is left over after deducting variable costs that could contribute to covering fixed costs and generating a profit. Fixed costs will be higher if the equipment is purchased due to the increased depreciation.

As part of this analysis, Mr. U. Bright should calculate the contribution margin ratio, which represents the amount of sales that are available to cover fixed costs and contribute to profit expressed as a percentage. The formula for calculating the contribution margin ratio is:

Contribution margin ratio = ((Sales - variable cost) / sales revenue) x 100%

The contribution margin ratio relating to Mr. U. Bright's decision would be:

Contribution Margin Ratio
Contribution Margin Ratio

Buying the equipment will lead to lower variable costs and a higher contribution margin ratio, which means it will generate profit faster than the current situation (70% vs. 50%).

Mr. U. Bright would also need to calculate the break-even level for his products, which represents the number of units that must be sold in order to cover costs. The amount of profit earned at the break-even point is zero. The formula for calculating the break-even point in units is:

Break-even point in units = Fixed costs / unit contribution margin

The formula for calculating the unit contribution margin is:

Unit contribution margin = Selling price per unit - variable cost per unit

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