Seminar 6

CVP Analysis & Budgeting

© 2018 Singapore University of Social Sciences. All rights reserved.

2
Learning Outcomes

• By the end of this unit, you should be able to:

– Describe cost behaviour in relation to the level of activity.
– Determine cost estimates using high-low, the scatter diagram,
and regression methods.
– Describe applications of cost-volume-profit analysis (CVP).
– Discuss a master budget and the procedures of preparing a
master budget.
– Analyse the link of operating and capital expenditures budgeting
to the budgeted income statement, and budgeted statement of
financial position.
 IDENTIFYING COST BEHAVIOR

Cost-volume-profit analysis is used to answer questions

such as:
– What sales volume is needed to earn a target income?
– What is the change in income if selling prices decline
and sales volume increases?
– How much does income increase if we install a new
machine to reduce labor costs?
– What is the income effect if we change the sales mix of
our products or services?
 Illustration

• For many business decisions, it is helpful to distinguish between how costs

behave, i.e. whether they are fixed or variable.
• Fixed costs: that do not change with increases in business activity such as
rent, advertising expense.
• Variable costs increase as a business produces more units a good.
• Mixed costs

 Finished bike is the cost object

© 2018 Singapore University of Social

Sciences. All rights reserved.
 FIXED COSTS

Cost per volume

Total costs

Production volume Production volume

Total fixed costs Cost per call
remain constant as declines as
activity increases. activity increases.
Examples – Rental, depreciation
 VARIABLE COSTS

Cost per Volume

Total Costs

Production volume Production volume

Total variable costs Cost per Minute
increase as is constant as
activity increases. activity increases.

Examples – Direct materials, direct labour

 Mixed Cost
• Something in between the two referred to as mixed costs.
• Mixed costs contain a fixed portion that is incurred even when the facility is unused, and a variable
portion that increases with
usage.
• Both variable and fixed components.
• Examples for mixed costs
– Compensation such as a base salary pay but plus some extra bonus.
• The firm pays the employees a fixed amount per month. And if the more they produce,
the more the employees can earn on top of the base pay.
• Total cost=Fixed cost + Variable cost
• Total cost=Fixed cost + Variable cost per unit x units produced
Total Cost

Variable Cost per volume

(Extra bonus)

Fixed Monthly Utility Charge

(Salary base)
Production volume
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 22 - 9

P1 MEASURING COST BEHAVIOR

The objective is to classify all costs as either fixed or variable.
1.Scatter diagrams.
2.The high-low method.
3. Least–squares regression.

The following relationships between units

produced and total cost are observed:

Using these two levels of activity, compute:

 the variable cost per unit.
 the total fixed cost.
 MEASURING COST BEHAVIOR

The objective is to classify all costs as either fixed

or variable. There are three methods:
1.Scatter diagrams.
2.The high-low method.
3. Least–squares regression.

We will focus on the high-lo method. Please read SU6

Chapter 1 for all three methods.
 THE HIGH-LOW METHOD

The following relationships between units

produced and total cost are observed:

Units Cost
High activity level - December 67,500 $ 29,000
Low activity level - January 17,500 20,500
Change in activity 50,000 $ 8,500

 Variable cost per unit =

 Fixed costs =

Using these two levels of activity, compute:

 the variable cost per unit. Total cost = $17,525 + $0.17
 the total fixed cost.
per unit produced
 22 - 11

P1

Δ in cost
Unit Variable Cost = Slope =
Δ in units

20

* ** * Vertical
1,000’s of Dollars

* * distance
Total Cost in

** is the
10 * * change in
cost.
Horizontal distance is
the change in activity.
0
Estimated fixed 0 1 2 3 4 5 6
cost = 10,000 Activity, 1,000’s of Units Produced
 Activity Q1

© 2018 Singapore University of Social

Sciences. All rights reserved.
 IDENTIFYING COST BEHAVIOR

Cost-volume-profit analysis is used to answer questions

such as:
– What sales volume is needed to earn a target income?
– What is the change in income if selling prices decline
and sales volume increases?
– How much does income increase if we install a new
machine to reduce labor costs?
– What is the income effect if we change the sales mix of
our products or services?
 Cost-Volume-Profit Analysis

• A method for understanding the relationship between profit, cost, and sales revenue is cost
volume profit analysis (or CVP)

• CVP permits sensitivity analysis. Sensitivity analysis is an approach to understanding how

changes in one variable (e.g. price) affect other variables (net profit).

1. The break even point is the point at which total costs equal total revenue. Net profit is 0.
• How many units have to be sold for the business to break even?

2. If fixed cost increases, and variable cost decreases by installing a new machine, what is
the income effect?

Sales $10 x 50units=$500 Formula

Less: Variable cost $3 x 50units=$150 Contribution margin=$350
Contribution margin (Sales-Variable cost) $7 x 50units=$350 Contribution margin per unit=$7
Less: Fixed cost $200 Contribution margin ratio=$7/$10=70%
Net profit $150

© 2017 Singapore University of Social

Sciences. All rights reserved.
 Break even point

1. The break even point is the point at which total costs equal total revenue. Net profit is 0.
– How many units have to be sold for the business to break even?
Sales $10 x ?units =$?
Variable cost $3 x ?units=$? Break-even point in units=$200/$7=28units
Contribution margin (Sales-Variable cost) $7 x ?units=$? Break-even point in dollars=$200/70%=$285
Fixed cost $200
Net profit $0

We need to sell more than 28 units to earn positive net profit

© 2017 Singapore University of Social

Sciences. All rights reserved.
 CVP Analysis

2. If fixed cost increases, and variable cost decreases by installing a new machine, what is the
income effect?

*Sales Budget, Target Profit

Sales $10x50units=$500
Variable cost $3x50units=$150
Contribution margin (Sales-Variable cost) $7x50units=$350
Fixed cost $200
Net profit $150

2. If we install a new machine to reduce labor costs, how much does income increase?

Sales $10x50units=$500
Variable cost $1x50units=$50
Contribution margin (Sales-Variable cost) $9x50units=$450
Fixed cost $250
Net profit $200

Net profit is increased to $200, which is higher than previous plan. Therefore, the company would purchase a new machine.

© 2018 Singapore University of Social

Sciences. All rights reserved.
 COMPUTING THE MARGIN OF SAFETY

Margin of safety is the amount by which sales can drop

before the company incurs a loss. Margin of safety may
be expressed as a percentage of expected sales.

Margin of safety Expected sales - Break-even sales

=
percentage Expected sales

If Rydell’s sales are $100,000 and break-even sales are

$80,000, what is the margin of safety percentage?
Margin of safety $100,000 - $80,000
= = 20%
percentage $100,000
© 2018 Singapore University of Social
Sciences. All rights reserved.
 Activity Q2

• Error Correction
– Total fixed cost was $2,500,000 (not $800,000)

© 2018 Singapore University of Social

Sciences. All rights reserved.
 Budget process

• Budget
– Is a plan expressed in monetary terms covering a future time period (typically a year).
– is an important tool for effective short-term planning and control.
– Is used for evaluating the performance of business units, their mangers and compensating

• Budget
– Implement strategy by allocating resources in line with strategic goals;
– Coordinate activities and assist in communication between different parts of the organization. Motivate
managers to achieve targets
– Control activities; and
– Evaluate managerial performance and compensate
• Favorable
– Actual net income is higher than what we budgeted (i.e., standard) net income.
• Unfavorable
– Actual net income lower than what we budgeted (i.e., standard) net income.

• Master budget
– The master plan for the organization for a given time period.

© 2018 Singapore University of Social Sciences. All rights reserved.

 23 - 6

C2
MASTER BUDGET COMPONENTS
1. Identify business objectives.
2. Forecast economic and industry conditions, including competition.

3. Sales 4. Merchandise
budget purchases

Develop detailed sales budgets Prepare purchase budget

by market sectors, (materials, labour, and overhead)
geographical territories, for the goods needed to satisfy
major customers, the sales forecast and
and product groups. maintain agreed levels of inventory.

5. Prepare
6. Prepare selling and
7. Cash forecasts capital general
expenditure administrative
8. Prepare
budget budgets
financial
budgets:
Income statement
Balance sheet
 Exercise

• Q10

© 2018 Singapore University of Social

Sciences. All rights reserved.
 23 - 9

P1
SALES BUDGET
In September 2011, Hockey Den sold 700 hockey sticks at $100 each. Hockey Den prepared the
following sales budget for the next four months:

HOCKEY DEN
Monthly Sales Budget
October 2011 – January 2012
Budgeted Budgeted Budgeted
Unit Sales Unit Price Total Sales
September 2011 (actual) 700 $ 100 $ 70,000

October 2011 1,000 $ 100 $ 100,000

November 2011 800 100 80,000
December 2011 1,400 100 140,000
Total 3,200 $ 100 $ 320,000

January 2012 900 $ 100 $ 90,000

 23 - 12

P1 MERCHANDISE PURCHASES BUDGET

Hockey Den buys hockey sticks for $60 each and maintains an ending inventory equal to 90
percent of the next month’s budgeted sales. On September 30, 900 hockey sticks are on hand.

HOCKEY DEN
Merchandise Purchases Budget
October 2011 – December 2011
October November December
Next month's unit sales 800 1,400 900
Ending inventory percentage × 90% × 90% × 90%
Budgeted ending inventory units 720 1,260 810
Add current month's unit sales 1,000 800 1,400
Total units needed 1,720 2,060 2,210
Deduct beginning inventory units 900 720 1,260
Number of units to be purchased 820 1,340 950
Budgeted cost per unit × $ 60 × $ 60 × $ 60
Budgeted cost of purchases $ 49,200 $ 80,400 $ 57,000

Beginning inventory is last month's ending inventory.

 SELLING EXPENSE BUDGET

 Hockey Den pays sales commissions equal to 10 percent of total sales.

 Hockey Den pays a monthly salary of $2,000 to its sales manager.

HOCKEY DEN
Selling Expense Budget
Jan 2020 – Mar 2020

Jan Feb Mar Total

Budgeted sales $ 100,000 $ 80,000 $ 140,000 $ 320,000
Sales commission % × 10% × 10% × 10% × 10%
Sales commission $ 10,000 $ 8,000 $ 14,000 $ 32,000
Sales manager's salary 2,000 2,000 2,000 6,000
Total selling expenses $ 12,000 $ 10,000 $ 16,000 $ 38,000

From Hockey Den’s sales budget

GENERAL AND ADMINISTRATIVE
EXPENSE BUDGET
• General and administrative salaries are $4,500
per month.
• Depreciation of equipment is $1,500 per month.

HOCKEY DEN
General and Administrative Expense Budget
Jan 2020 – Mar 2020
Jan Feb Mar Total
Administrative salaries $ 4,500 $ 4,500 $ 4,500 $ 13,500
Equipment depreciation 1,500 1,500 1,500 4,500
Total $ 6,000 $ 6,000 $ 6,000 $ 18,000
 CAPITAL EXPENDITURES BUDGET

 Hockey Den does not anticipate

disposal of any plant assets
through March 2020, but
management is planning to
acquire additional equipment for
$25,000 cash in March 2020.
 Since this is the only budgeted
capital expenditure for the
quarter, no separate budget is
shown.
BUDGETED CASH RECEIPTS
• Forty percent of Hockey Den’s sales are for cash.
• The remaining 60 percent are credit sales that are
collected in full in the month following the sale.

HOCKEY DEN
Cash Receipts Budget
Jan 2020 - Mar 2020
Dec-19 Jan-20 Feb-20 Mar-20
Budgeted sales $ 70,000 $ 100,000 $ 80,000 $ 140,000
Accounts receivable $ 42,000 $ 60,000 $ 48,000 $ 84,000
Cash receipts from:
Cash sales $ 40,000 $ 32,000 $ 56,000
Collection of receivables 42,000 60,000 48,000
Total cash receipts $ 82,000 $ 92,000 $ 104,000

60% of sales
CASH DISBURSEMENTS
FOR PURCHASES
• Hockey Den’s purchases of merchandise are entirely on
account.
• Full payment is made in the month following the purchase.
• The December 31 balance of Accounts Payable is $58,200.

HOCKEY DEN
Cash Disbursements for Purchases
Jan 2020 - Mar 2020
Jan payments $ 58,200
Feb payments 49,200
Mar payments 80,400

From merchandise purchases budget

 Budgeted Income Statement & Balance Sheet

Hockey Den
Budgeted Income Statement
For Three Months Ended March 31, 2020

Hockey Den
Budgeted Balance Sheet
March 31, 2020
 • Final Exam:
– TOA (Times Assigned Assignment)
– students@suss.edu.sg
– You can email to me by 15 May 11:59pm.
– gracekangij@suss.edu.sg

© 2018 Singapore University of Social

Sciences. All rights reserved.