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Ch 9 - summary

ADMS 2510 (York University)

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Ch 9 - short term profit planning : cost volume profit analysis (cvp)

CVP analysis

• CVP analysis is a method for analyzing how various operating decisions and marketing
decisions affect short-term operating profit

• CVP analysis depicts the short-term profit structure of an organization

• CVP analysis models the relationship between operating profit and the following factors that
combine to determine the level of short-term profits:

– variable cost per unit

– total fixed costs
– unit selling price
– output level (volume), and
– sales mix

- Operating profit = sales - total costs

For convenience, the (single-product) model is commonly shown in symbolic form:

π B = (p × Q) − (v × Q) − F

Where:

Q =units sold (i.e., sales volume)

P =selling price per unit
F =total fixed cost
V =variable cost per unit
π (b) = operating profit (before tax)

Concept regarding CVP model : contribution margin ( cm )

• Unit contribution margin (cm) = Unit sales price (p) – Unit variable cost (v)
- (p – v)

• Total contribution margin $ (CM) = Unit contribution margin (cm) × Units sold (Q)]
- Cm x Q

Contribution margin ratio = Unit contribution margin (cm)÷ unit sales price (p)
= (p – v) ÷ p =
- cm ÷ p or ( total cm/total sales )

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The contribution income statement:

• A useful way to show information developed in CVP analysis

• Classifies costs based on cost behavior (fixed versus variable) rather than cost type (product
versus period)
• Provides an easy approach to predicting the effect of a change in sales on operating profit

Strategic role of cvp analysis

- CVP analysis can help a firm choose its competitive position and execute its strategy by
providing an understanding of how changes in sales volume affect costs and profits:

– This process is most important for cost leadership firms during the manufacturing stage

– Differentiated firms use CVP analysis to assess profitability and desirability of new products
and features

- CVP analysis is also important in life-cycle costing and target costing :

– CVP analysis can assist in life-cycle costing by helping to determine whether a product is
likely to achieve its desired profitability, the most cost-effective manufacturing process, the best
marketing and distribution channels, the best compensation plan, whether to offer discounts,
etc.

– CVP analysis can assist in target costing by showing the effect on profit of alternative product
designs that have different target costs

Key Assumptions of CVP Analysis

1. Selling price is constant.

2. Costs are linear and can be accurately divided into variable (constant per unit) and fixed
(constant in total) elements.

3. In multiproduct companies, the sales mix is constant.

4. In manufacturing companies, inventories do not change (units produced = units sold).

Cvp for break-even point

Determining the “breakeven point” is the starting point of many business plans:

– Breakeven is the point at which revenues equal total costs and profit is zero
– The breakeven (B/E) point can be determined in either of two ways:

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1. Based on Units Sold (Q)

2. Based on Sales Dollars (Y)

1. Breakeven in Units, Q (@ B/E, π B = $0)

$0 = (p × Q) − (v × Q) − F
$0 = (p − v)Q − F
F = (p − v)Q

Q = F/(p − v)
That is, Q = Fixed costs ÷ contribution margin per unit

2. Breakeven in Sales Dollars, Y (@ B/E, π B = $0)

Operating profit = Sales − total variable costs − Fixed costs

$0 = (p × Q) − (v × Q) − F
$0 = [p × (Y/p)] − [v × (Y/p)] − F
p × (Y/p) = [v × (Y/p)] + F
Y = [(v/p) × Y ] + F

Y = F ÷ (p − v)/p
Y = fixed costs ÷ contribution margin ratio

- The contribution margin method has two key equations :

1. Break-even point in units sold = Fixed expenses / CM per unit

2. Break-even point in total sales dollars = Fixed expenses / CM ratio

Cvp graph and profit-volume graph

• The CVP graph illustrates how the levels of revenues and total costs change as output (sales
volume) changes
• A profit-volume (PV) graph illustrates how the level of operating profit changes as output (sales
volume) changes
– This graph allows a person to clearly see how total contribution margin, and therefore profit,
changes as the output level (i.e., volume) changes
Cvp analysis and profit planning

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CVP analysis can be used to determine the sales volume needed to achieve a desired level of
before tax profit, π B :

- Q=F+πB/P-V
- Y ($) = P x Q

Indifference point : can help determine between 2 trade-offs, machine A or machine B.

- B/E analysis can help HFI find the level of sales (called the “indifference point”), such
that having sales > than this level will favor the option with the higher fixed costs, and
having sales < this level will favor the low fixed cost option.
Ex :
Cost of Machine A = Cost of Machine B
$5,000 + ($10 × Q) = $15,000 + ($5 × Q)
Q = $10,000 ÷ $5/unit
Q = 2,000 units

Income taxes and CVP analysis

• Management decisions about costs and prices usually must include income taxes because
taxes affect the amount of net profit at a given level of sales

• The approach is to express desired after-tax profits (πA) profits in terms of pre-tax dollar
equivalents (π B ), for a given tax rate, t

- Q = F +( π A / 1-t) / p-v

Cvp analysis and ABC - ch 5

Dealing with Risk and Uncertainty

Sensitivity analysis is the name for a variety of methods that examine how an amount (e.g., B/E
point) changes if factors involved in predicting that amount change (e.g., sales volume or unit
variable cost). For CVP, three methods of sensitivity analysis are commonly employed:

(1) What-if analysis (using the contribution margin and contribution margin ratio)

(2) Construction of decision tables/decision trees/expected value analysis

(3) Expected value analysis

Risk and Margin of saftey

Margin of safety (MOS) is the dollar amount of sales above the B/E point (i.e., forecasted (or

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actual) sales level minus the B/E sales level):

- MOS = planned (or actual) sales − break even sales (in units or in dollars)

- Margin of safety ratio (MOS%)

= MOS ÷ planned (or actual) sales volume
= the percentage that sales could fall (from planned or actual levels) before losses occur

Handling risk and degree of operating leverage

• Operating leverage refers to the extent of fixed costs in the cost structure of an organization.
The greater the operating leverage, the greater the operating risk (i.e., not being able to cover
fixed costs via operations).

• Degree of operating leverage (DOL), at any sales volume level, Q, represents the sensitivity of
operating income to changes in sales volume.

DOL = CM ÷ operating profit

The Five Steps of Strategic Decision Making for CVP Analysis: A Real Estate Business
Example

1. Determine the Strategic Issues Surrounding the Problem: the business competes on quality
and reliability of service

2. Identify the Alternative Actions: choose among printer and cartridge options

3. Obtain Information and Conduct Analyses of the Alternatives: CVP analysis favors the larger
cartridge and determines an indifference point for the new printer

4. Based on Strategy and Analysis, Choose and Implement the Desired Alternative: because of
concerns for the print quality of the new printer, the current printer is chosen

5. Provide an On-going Evaluation of the Effectiveness of implementation in Step 4.

CVP Analysis with Two or More Products/Services

• If all fixed costs are traceable to individual products, then the organization can develop a
separate CVP model for each product

• Alternatively, the multi-product firm can make an assumption regarding a standard sales mix in
which its products are sold

• Sales mix can be determined on the basis of sales dollars or unit sales

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• The assumption of sales mix allows the firm to calculate and use a weighted-average
contribution margin (cm) per unit and weighted average cm ratio to complete the multi-product
CVP analysis

Assumptions/Limitations of Conventional CVP Analysis :

• The CVP model assumes revenues and costs are linear over a “relevant range” (even though
the actual cost behavior may not be linear)

• Outside the relevant range, these calculations may not be accurate

• Step costs also make approximation via the relevant range unworkable; CVP analysis
becomes much more cumbersome

• The basic model is deterministic.

The Concept of Sales Mix

• Sales mix is the relative proportion in which a company’s products are sold.

• Different products have different selling prices, cost structures, and contribution margins.

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