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CHAPTER 1:

COST-VOLUME-PROFIT
ANALYSIS: A MANAGERIAL
PLANNING TOOL
Cornerstones of Managerial
Accounting, 5e in chapter 4 page 116

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Learning Objectives
1. Determine the break-even point in number of units
and in total sales dollars.
2. Determine the number of units that must be sold,
and the amount of revenue required, to earn a
targeted profit.
3. Prepare a profit-volume graph and a cost-volume-
profit graph, and explain the meaning of each.
4. Apply cost-volume-profit analysis in a multiple-
product setting.
5. Explain the impact of risk, uncertainty, and changing
variables on cost-volume-profit analysis.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
Break-Even Point
in Units and Sales Dollars
 Cost-volume-profit (CVP) analysis estimates
how changes in the following three factors affect
a company’s profit.
 Costs (both variable and fixed)
 Sales volume
 Price
 Companies use CVP analysis to help them reach
important benchmarks, like breakeven point.

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Break-Even Point in Units and in
Sales Dollars (cont.)
 The break-even point is the point where total
revenue equals total cost (i.e., the point of zero
profit).
 The level of sales at which contribution margin just
covers fixed costs and when operating income is
equal to zero.
 If new companies experience losses (negative
operating income) initially, they view their first
break-even period as a significant milestone.
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Break-Even Point in Units and in
Sales Dollars (cont.)

CVP analysis can address many


other issues:

1 The number of units that must be


sold to break even

2 The impact of a given reduction


in fixed costs on the break-even point

3 The impact of an increase in


price on profit
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Using Operating Income
in Cost-Volume-Profit Analysis (cont.)

Direct Variable selling and


materials administrative costs
Direct labor

Variable
overhead

Fixed selling and


Fixed administrative costs
overhead
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Using Operating Income in
Cost-Volume-Profit Analysis (cont.)

Contribution margin is the difference between


sales and variable expense. It is the amount of sales
revenue left over after all the variable expenses are
covered that can be used to contribute to fixed
expense and operating income.

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Cornerstone 4.1
Preparing a Contribution Margin
Income Statement

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Cornerstone 4.1
Preparing a Contribution Margin
Income Statement (cont.)

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Cornerstone 4.1
Preparing a Contribution Margin
Income Statement (cont.)

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Break-Even Point in Units
 If the contribution margin income statement is
recast as an equation, it becomes more useful for
solving CVP problems.

 Basic CVP Equations:

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Cornerstone 4.2
Calculating the Break-Even
Point in Units

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Cornerstone 4.2
Calculating the Break-Even Point in Units
(cont.)

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Break-Even Point in Units
 If the contribution margin income statement is
recast as an equation, it becomes more
 useful for solving CVP problems.

Basic CVP
Equation

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Break-Even Point in Units (cont.)
 Break-even units are equal to the fixed cost
divided by the contribution margin per unit.

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Break-Even Point in Sales Dollars
 Managers using CVP analysis may use sales
revenue as the measure of sales activity instead
of units sold. A units sold measure can be
converted to a sales revenue measure by
multiplying the unit selling price by the units sold:

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Break-Even Point in Sales Dollars

For example, the break-even point for Whittier is 600


mowers; the selling cost is $400 per mower.
Breakeven in Sales $’s = 600 x $400 = $240,000

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Variable Cost Ratio and Contribution Margin Ratio

Any answer expressed in units sold can be easily


converted to one expressed in sales revenues.

Variable Cost Ratio Contribution Margin Ratio

Alternatively:

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Cornerstone 4.3
Calculating the Variable Cost Ratio and the
Contribution Margin Ratio

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Cornerstone 4.3
Calculating the Variable Cost Ratio
and the Contribution Margin Ratio (cont.)

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Fixed Cost’s Relationship, Variable
Cost Ratio, Contribution Margin Ratio
 Since the total contribution margin is the revenue
remaining after total variable costs are covered, it
must be the revenue available to cover fixed
costs and contribute to profit.
 How does the relationship of fixed cost to
contribution margin affect operating income?

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Fixed Cost’s Relationship, Variable
Cost Ratio, Contribution Margin Ratio (cont.)

 There are three possibilities:


 Fixed cost equals contribution margin; operating
income is zero; the company breaks even.
 Fixed cost is less than contribution margin;
operating income is greater than zero; the
company makes a profit.
 Fixed cost is greater than contribution margin;
operating income is less than zero; the company
makes a loss.
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Units to Be Sold to
Achieve a Target Income
 The break-even point is useful information and an
important benchmark for relatively young
companies, most companies would like to earn
operating income greater than $0.
 CVP allows us to do this by adding the target
income amount to the fixed cost.
 First, let’s look in terms of units that must be sold.

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Calculating Break-Even in Sales
Dollars
 The equation to figure the break-even sales
dollars is:

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Cornerstone 4.4
Calculating the Break-Even Point
in Sales Dollars

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Cornerstone 4.4
Calculating the Break-Even Point
in Sales Dollars (cont.)

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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
Cornerstone 4.4
Calculating the Break-Even Point
in Sales Dollars (cont.)

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Cornerstone 4.5
Calculating Number of Units to Be Sold to
Earn A Target Operating Income (cont.)

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Cornerstone 4.5
Calculating Number of Units to Be Sold to
Earn A Target Operating Income (cont.)

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Sales Revenue to Achieve a Target Income (cont.)

 To answer the question, add the targeted


operating income of $37,500 to the $45,000 of
fixed cost and divide by the contribution margin
ratio. This equation is:

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Sales Revenue to
Achieve a Target Income
 How much sales revenue must Whittier generate
to earn an operating income of $37,500?
 This question is similar to the one we asked
earlier in terms of units but phrases the question
directly in terms of sales revenue.

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Cornerstone 4.6
Calculating Sales Needed to
Earn a Target Operating Income

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Cornerstone 4.6
Calculating Sales Needed to
Earn A Target Operating Income (cont.)

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Impact of Change in Revenue
on Change in Profit
 Assuming that fixed costs remain unchanged, the
contribution margin ratio can be used to find the
profit impact of a change in sales revenue.
 To obtain the total change in profits from a
change in revenues, multiply the contribution
margin ratio times the change in sales:

Change Contribution Change


in = Margin x in
Profits Ratio Sales
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Cost-Volume-Profit Relationships:
The Profit-Volume Graph
 A profit-volume graph visually portrays the
relationship between profits (operating income)
and units sold.
 The profit-volume graph is the graph of the
operating income equation:
Operating income = (Price x Units) –
(Unit variable cost x Units) – Total fixed cost
 In the following graph, operating income is the
dependent variable, and units is the independent
variable. LO-3
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Cost-Volume-Profit Relationships:
The Profit-Volume Graph
 A profit-volume graph visually portrays the
relationship between profits (operating income)
and units sold.

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The Cost-Volume-Profit Graph

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CVP Analysis Assumptions
Major assumptions of CVP analysis include:
1 2
Linear revenue and cost
Selling prices and costs
functions remain
are known with
constant over the
certainty.
relevant range.

3 4
Sales mix is known with
All units produced are
certainty for multiple-
sold; no finished goods
product break-even
inventories remain.
settings. LO-3
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Multiple-Product Analysis
 Cost-volume-profit analysis is simple in the
single-product setting. However, most firms
produce and sell a number of products or
services.
 How do we adapt the formulas used in a single-
product setting to a multiple-product setting?

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Multiple-Product Analysis (cont.)
 One important distinction is to separate direct
fixed expenses from common fixed expenses.
 Direct fixed expenses are those fixed costs that can
be traced to each segment and would be avoided if the
segment did not exist.
 Common fixed expenses are the fixed costs that are
not traceable to the segments and would remain even if
one of the segments was eliminated.

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Break-Even Calculations
for Multiple Products
 When more than one product is produced and
sold, managers must estimate the sales mix and
calculate a package contribution margin.
 Sales mix is the relative combination of products
being sold by a firm.

Fixed Costs
Break-Even Packages =
Package Contribution Margin

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Cornerstone 4.7
Calculating The Break-Even Units
for a Multiple-Product Firm (cont.)

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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
Cornerstone 4.7
Calculating The Break-Even Units
for a Multiple-Product Firm (cont.)

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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
Cornerstone 4.7
Calculating The Break-Even Units
for a Multiple-Product Firm (cont.)

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Cornerstone 4.8
Break-Even Sales Dollars
for a Multiple-Product Firm (cont.)

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Cornerstone 4.8
Break-Even Sales Dollars
for a Multiple-Product Firm (cont.)

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Cost-Volume-Profit Analysis and
Risk and Uncertainty
 Managers must be aware of so many factors in
our dynamic world. CVP analysis is a tool that
managers use to handle risk and uncertainty.

?
h an g es in Risks?
C
?
prices?

Fixed
?
ainty?? costs?
r t
Unce
Variable
costs??
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Introducing Risk and Uncertainty
 An important assumption of CVP analysis is that
prices and costs are known with certainty.
 However, risk and uncertainty are a part of
business decision making and must be dealt with
somehow.

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Methods to Deal with
Uncertainty and Risk

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Margin of Safety and
Operating Leverage

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Margin of Safety
 The margin of safety is the units sold or the
revenue earned above the break-even volume.
 For example, if the break-even volume for a
company is 200 units and the company is currently
selling 500 units, the margin of safety in units is:

Sales - Break-even units = 500 – 200 = 300 units

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Margin of Safety (cont.)
 If the break-even volume for a company is
$200,000 and the current revenues are $500,000,
the margin of safety in sales revenue is:
Revenue - Break-even volume
= $500,000 – 200,000 = $300,000
 The margin of safety as a percentage of total
sales dollars can then be expressed as:
Margin of safety ÷ Revenues
= $300,000 ÷ $500,000 = 60%
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Cornerstone 4.9
Computing the Margin of Safety

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Operating Leverage
 Operating leverage is use of fixed costs to
extract higher percentage changes in profits as
sales activity changes.
 Measure of the proportion of fixed costs in a
company’s cost structure.
 It is used as an indicator of how sensitive profit is
to changes in sales volume.

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Operating Leverage
 The degree of operating leverage (DOL) can be
measured for a given level of sales by taking the
ratio of contribution margin to operating income
or:
Contribution margin ÷ Operating income

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Cornerstone 4.10
Computing the Degree of
Operating Leverage

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Cornerstone 4.10
Computing the Degree of
Operating Leverage (cont.)

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Summary of Operating Leverage

Operating Leverage
HIGH LOW
% profit increase with sales Large Small
increase

% loss increase with sales Large Small


decrease

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Sensitivity Analysis

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