# Effect of Change in Fixed Cost and Sales Volume on Contribution Margin and Profitability:

Learning Objectives:

1. What is the effect of change in fixed costs and sales volume on contribution margin and profitability?

The following data is used to show how changes in fixed costs and sales volume can effect company’s contribution margin and profitability.

Basic Data:
Selling price: \$250 (100%)
Variable Expenses: \$150 (60%)
Contribution Margin: \$250 – \$150 = \$100 (40%)
Fixed Expenses: \$35,000 per month

Suppose that a company is currently selling 400 units per month (monthly sales of \$100,000).The sales manager feels that a \$10,000 increase in the advertising budget would increase monthly sales by \$30,000 to a total of 520 units. Should the advertising budget be increased? The following table shows the effect of the proposed change in the monthly advertising budget.

 Current Sales Sales with additional advertising budget Difference Percent of sales Sales \$100,000 \$130,000 \$30,000 100% Less variable expenses \$60,000 \$78,000 \$18,000 60% ——— ——— ——— ——— Contribution margin 40,000 52,000 12,000 40% Less fixed expenses 35,000 45,000 10,000 ====== ——— ——— ——— Net operating income \$5,000 \$7,000 \$2,000 ====== ====== ======

Assuming no other factors need to be considered, the increase in the advertising budget should be approved since it would lead to an increase in net operating income of \$2,000. There are two shorter ways to present this solution. The first alternate solution follows:

Alternative Solution 1:

 Expected total contribution margin: \$130,000 × 40% CM ratio \$52,000 Present total contribution margin: \$100,000 × 40% CM ratio 40,000 ——— Incremental contribution margin 12,000 Less incremental advertising expenses 10,000 ——— Increased net operating income \$2,000 =======

Since in this case the fixed costs and the sales volume change, the solution can be presented in an even shorter format.

Alternative Solution 2:

 Incremental contribution margin: \$30,000 × 40% Contribution Margin ratio \$12,000 Less incremental advertising expenses 10,000 ——— Increased net operating income \$2,000

Notice that this approach does not depend on knowing of previous sales. Also notice that it is unnecessary under either shorter approach to prepare an income statement. Both of the solutions above involve an incremental analysis. They consider only those items of revenue, cost, and volume that will change if the new program is implemented. Although in each case a new income statement could have been prepared, the incremental approach is simpler and more direct and focuses attention on the specific items involved in the decision.