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Cost-VolumeProfit Analysis: A Managerial Planning Tool

PowerPresentation prepared by David J. McConomy, Queens University

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Learning Objectives
q

Determine the number of units that must be sold to break even or to earn a targeted profit. Determine the amount of revenue required to break even or to earn a targeted profit.

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Learning Objectives (continued)

q

Apply cost-volume-profit analysis in a multiple-product setting. Prepare a profit-volume graph and a cost-volume-profit graph and explain the meaning of each.

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Learning Objectives (continued)

q

Explain the impact of risk, uncertainty, and changing variables on costvolume-profit analysis. Discuss the impact of activity-based costing on cost-volume-profit analysis.

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Sample Questions Raised and Answered by CVP Analysis

1. How many units must be sold (or how much sales revenue must be generated) in order to break even? 2. How many units must be sold to earn a before-tax profit equal to $60,000? A before-tax profit equal to 15 percent of revenues? An after-tax profit of $48,750? 3. Will total profits increase if the unit price is increased by $2 and units sold decrease 15 percent? 4. What is the effect on total profit if advertising expenditures increase by $8,000 and sales increase from 1,600 to 1,750 units?
Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Sample Questions Raised and Answered by CVP Analysis (continued)

5. What is the effect on total profit if the selling price is decreased from $400 to $375 per unit and sales increase from 1,600 units to 1,900 units? 6. What is the effect on total profit if the selling price is decreased from $400 to $375 per unit, advertising expenditures are increased by $8,000, and sales increased from 1,600 units to 2,300 units? 7. What is the effect on total profit if the sales mix is changed?

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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CVP: A Short-Term Planning and Analysis Tool

Benefits of CVP:
q q q

Assists in establishing prices of products. Assists in analyzing the impact that volume has on short-term profits. Assists in focusing on the impact that changes in costs (variable and fixed) have on profits. Assists in analyzing how the mix of products affects profits.
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Copyright 2004 by Nelson, a division of Thomson Canada Limited.

Cost-Volume-Profit Graph
Revenue Total Revenue

Profit Y Loss

Total Cost

Units sold

X = Break-even point in units Y = Break-even point in revenue

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Simple CVP Example

Fixed costs (F) Selling price per unit (P) Variable cost per unit (V) Tax rate = = = = $40,000 $10 $6 40%

1. What is the break-even point in units?

2. What is the break-even point in dollars?

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Simple CVP Example: BEP

1. Let X = break-even point in units Operating income = Sales revenue -Variable expenses - Fixed expenses 0 =$10X -$6X - $40,000 $10X - $6X =$40,000 $4X =$40,000 X =10,000 units 2. Break-even point in sales dollars is: 10,000 x $10 or $100,000 This can be shown with a variable-costing income statement.
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Copyright 2004 by Nelson, a division of Thomson Canada Limited.

Variable-Costing Income Statement

Sales (10,000 x $10) Less: Variable costs (10,000 x $6) Contribution margin Less: Fixed costs Profit before taxes Less: Income taxes Profit after taxes $100,000 60,000 $ 40,000 40,000 $0 0 $ 0

=====

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Sales Revenue Approach

Alternative approach: break-even point in sales dollars: Let X equal break-even sales in dollars Operating income = Sales revenue - Variable expenses Fixed expenses 0 = X - 0.6X - $40,000 X - 0.6X = $40,000 0.4X = $40,000 X = $100,000 Note: V is the variable cost percentage which is found by: Variable Cost per Unit 6 Selling Price per Unit 10 = 0.6

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Targeted Pretax Income

What sales in units and dollars are needed to obtain a targeted profit before taxes of $20,000?
Let X = break-even point in units Sales Less: Variable costs Contribution margin Less: Fixed costs Profit before taxes Therefore, $ = $10X = 6X $60,000 = $ 4X 40,000 $20,000

CVP Example:

====

$60,000 = $4X 15,000 units = X Sales in dollars is (15,000 x $10) = $150,000. Check this by completing the variable-costing income statement.
Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Targeted Pretax Income (continued)

CVP Example:

Sales Less: Variable costs Contribution margin Less: Fixed costs Profit before taxes It checks!

$150,000 = 15,000 x $10 90,000 = 15,000 x $6 $ 60,000 40,000 $ 20,000 =======

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Targeted After-Tax Income

What sales in units and dollars are needed to obtain a targeted profit after taxes of $24,000?
Let X = break-even point in units
Sales Less: Variable costs Contribution margin Less: Fixed costs Profit before taxes Less income taxes Profit after taxes $ $ $ 40,000 $ $24,000 ====== = $10X = 6X = $ 4X

CVP Analysis:

We have the same problem as PPT 9-13 assuming we are able to find the profit before taxes.
Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Targeted After-Tax Income (continued)

The Approach: AFTER BEFORE AFTER $24,000 $24,000/.6 $40,000 = = = = = = Profit after taxes Profit before taxes (1 - tax rate) x BEFORE (1 - .4) x BEFORE BEFORE BEFORE

CVP Analysis:

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Targeted After-Tax Income (continued)

Therefore, Sales Less: Variable costs Contribution margin Less: Fixed costs Profit before taxes Less: Income taxes Profit after taxes $ = $10X = $ 6X

CVP Analysis:

$80,000 = $ 4X 40,000 $40,000 16,000 = 40% of $40,000 $24,000 ======

$4X = $80,000 X = $80,000/$4 X = 20,000 units Sales in dollars is (20,000 x $10) or $200,000
Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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CVP Analysis:
Targeted After-Tax Income (continued)
The income statement below illustrates that $200,000 in sales will give you an after-tax profit of $24,000.
Sales Less: Variable costs Contribution margin Less: Fixed costs Profit before taxes Less: Income taxes Profit after taxes $200,000 120,000 $ 80,000 40,000 $ 40,000 16,000 $ 24,000

======

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Targeted Pretax Income

What sales in dollars is needed to obtain a targeted profit before taxes equal to 20 percent of sales?
Let X = sales in dollars
Sales Less: Variable costs Contribution margin Less: Fixed costs Profit before taxes = = $40,000 + .2X = $40,000 $ 1.0X 0.6X 0.4X .2X

CVP Analysis:

.4X .2X X X

= = = =

$40,000 + .2X $40,000 $40,000/.2 $200,000

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Copyright 2004 by Nelson, a division of Thomson Canada Limited.

Targeted Pretax Income (continued)

CVP Analysis:

The following variable-costing income statement can be used to check the solution. Sales Less: Variable costs Contribution margin Less: Fixed costs Profit before taxes $200,000 120,000 = .6 ($200,000) $ 80,000 = .4 ($200,000) 40,000 $ 40,000 ======= $40,000 is 20% of $200,000. It checks!

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Targeted After-Tax Income

What sales in dollars is needed to obtain a targeted profit after taxes equal to 6 percent of sales?
Let X = sales in dollars
Sales Less: Variable costs Contribution margin Less: Fixed costs Profit before taxes Less: Income taxes Profit after taxes $ $ 40,000 $ $ .06X = = = 1.0X 0.6X 0.4X

CVP Analysis:

=====

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Targeted After-Tax Income (continued)

Use the method from PPT 9-16 AFTER = (1- tax rate) x BEFORE 0.06X = (1 - .4) x BEFORE 0.06X / 0.6 = BEFORE 0.1X = BEFORE Therefore, Sales Less: Variable costs Contribution margin Less: Fixed costs Profit before taxes Less: Income taxes Profit after taxes = = $ 40,000 + .1X = 40,000 0.10X 0.04X 0.06X $ 1.0X 0.6X 0.4X

CVP Analysis:

======

.4X .3X X X

= = = =

40,000 + .1X 40,000 $40,000/.3 $133,333

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Copyright 2004 by Nelson, a division of Thomson Canada Limited.

CVP Analysis:
Targeted After-Tax Income (continued)
The following income statement checks the solution: Sales Less: Variable costs Contribution margin Less: Fixed costs Profit before taxes Less: Income taxes Profit after taxes $8,000 is 6% of $133,333. It Checks! $133,333 80,000 = .6 x $133,333 $ 53,333 40,000 $ 13,333 5,333 = .4 x $13,333 $ 8,000 =======

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Multiple-Product Example

Product A B

P $10 8

V $6 5

= = =

CM $4 3

x x x

Mix 3 2

= Total CM = $12 = 6 $18 ===

Total CM per package

Total fixed expenses = $180,000

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Multiple-Product Example (continued)

Break-even point: X = Fixed cost / Unit contribution margin = $180,000 / $18 = 10,000 packages to break even Each package contains 3 units of A and 2 units of B. Therefore, to break even, we need to sell the following units of A and B: A: 3 B: 2 x10,000 x10,000 = = 30,000 units 20,000 units

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Another Multiple-Product Example

Assume the following: Regular
Units sold Sales price per unit Sales Less: Variable expenses Contribution margin Less: Fixed expenses Net income 1. 2.

Deluxe

Total Percent
------100.0% 51.4 48.6% 130,000 $ 40,000 =======

400 200 600 $500 $750 ---$200,000 $150,000 $350,000 120,000 60,000 180,000 $ 80,000 $ 90,000 $170,000

What is the break-even point? How much sales-revenue of each product must be generated to earn a before tax profit of $50,000?
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Copyright 2004 by Nelson, a division of Thomson Canada Limited.

Another Multiple-Product Example: BEP

BEP = = = Fixed cost / CM ratio for sales mix $130,000 / 0.486 $267,490 for the firm

BEP for Regular Model: (400/600) x $267,490 = $178,327 BEP for Deluxe Model: (200/600) x $267,490 = $89,163

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Another Multiple-Product Example: Targeted Revenue

BEP = (Fixed Costs + Targeted income) / CM ratio per sales mix = ($130,000 + $50,000) / 0.486 = $370,370 for the firm

BEP for Regular Model: (400/600) x $370,370 = $246,913 BEP for Deluxe Model: (200/600) x 370,370 = $123,457

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Profit-Volume Graph

Profit

I = (P-V)X-F Slope = P-V

Profit loss break-even point in units UNITS

-F

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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The Limitations of CVP Analysis

A number of limitations are commonly mentioned with respect to CVP analysis: 1. 2. The analysis assumes a linear revenue function and a linear cost function. The analysis assumes that price, total fixed costs, and unit variable costs can be accurately identified and remain constant over the relevant range. The analysis assumes that what is produced is sold. For multiple-product analysis, the sales mix is assumed to be known. The selling prices and costs are assumed to be known with certainty.

3. 4. 5.

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Margin of Safety
Assume that a company has the following projected income statement:
Sales Less: Variable expenses Contribution margin Less: Fixed expenses Income before taxes $100,000 60,000 $ 40,000 30,000 $ 10,000 =======

Break-even point in dollars (R):

R = $30,000/.4 Safety margin = $100,000 - $75,000 = $75,000 = $25,000

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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Degree of Operating Leverage (DOL)

DOL = $40,000/$10,000 = 4.0 Now suppose that sales are 25% higher than projected. What is the percentage change in profits? Percentage change in profits = DOL x percentage change in sales Percentage change in profits = 4.0 x 25% = 100%

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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DOL (continued)

Proof: Sales Less: Variable expenses Contribution margin Less: Fixed expenses Income before taxes $125,000 75,000 $ 50,000 30,000 $ 20,000 ======

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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CVP and ABC

Assume the following:
Sales price per unit Variable cost Fixed costs (conventional) Fixed costs (ABC) analysis Other Data: $15 5 $180,000 100,000 with $80,000 subject to ABC

Activity Driver Setups Inspections

Unit Variable Costs $500 50

Level of Activity Driver 100 600

1. What is the BEP under conventional analysis? 2. What is the BEP under ABC analysis? 3. What is the BEP if setup cost could be reduced to $450 and inspection cost reduced to $40?
Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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CVP and ABC (continued)

1. Break-even units (conventional analysis) BEP = $180,000/$10 = 18,000 units

2. Break-even units (ABC analysis) BEP 3. BEP = [$100,000 + (100 x $500) + (600 x $50)]/$10 = 18,000 units = [$100,000 + (100 x $450) + (600 x $40)]/$10 = 16,900 units

What implications does ABC have for improving performance?

Copyright 2004 by Nelson, a division of Thomson Canada Limited.

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