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COST-VOLUME-PROFIT

ANALYSIS: A MANAGERIAL

PLANNING TOOL

Cornerstones of Managerial

Accounting, 5e in chapter 4 page 116

© 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

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.

LO-1

© 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 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.

LO-1

© 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 in

Sales Dollars (cont.)

other issues:

sold to break even

in fixed costs on the break-even point

price on profit

LO-1

© 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

Using Operating Income

in Cost-Volume-Profit Analysis (cont.)

materials administrative costs

Direct labor

Variable

overhead

Fixed administrative costs

overhead

LO-1

© 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

Using Operating Income in

Cost-Volume-Profit Analysis (cont.)

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.

LO-1

© 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 4.1

Preparing a Contribution Margin

Income Statement

LO-1

© 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 4.1

Preparing a Contribution Margin

Income Statement (cont.)

LO-1

© 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 4.1

Preparing a Contribution Margin

Income Statement (cont.)

LO-1

© 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

If the contribution margin income statement is

recast as an equation, it becomes more useful for

solving CVP problems.

LO-1

© 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 4.2

Calculating the Break-Even

Point in Units

LO-1

© 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 4.2

Calculating the Break-Even Point in Units

(cont.)

LO-1

© 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

If the contribution margin income statement is

recast as an equation, it becomes more

useful for solving CVP problems.

Basic CVP

Equation

LO-1

© 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 (cont.)

Break-even units are equal to the fixed cost

divided by the contribution margin per unit.

LO-1

© 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 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:

LO-1

© 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 Sales Dollars

mowers; the selling cost is $400 per mower.

Breakeven in Sales $’s = 600 x $400 = $240,000

LO-1

© 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

Variable Cost Ratio and Contribution Margin Ratio

converted to one expressed in sales revenues.

Alternatively:

LO-1

© 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 4.3

Calculating the Variable Cost Ratio and the

Contribution Margin Ratio

LO-1

© 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 4.3

Calculating the Variable Cost Ratio

and the Contribution Margin Ratio (cont.)

LO-1

© 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

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?

LO-1

© 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

Fixed Cost’s Relationship, Variable

Cost Ratio, Contribution Margin Ratio (cont.)

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.

LO-1

© 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

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.

LO-2

© 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

Calculating Break-Even in Sales

Dollars

The equation to figure the break-even sales

dollars is:

LO-1

© 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

LO-1

© 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.)

LO-1

© 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.)

LO-1

© 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 4.5

Calculating Number of Units to Be Sold to

Earn A Target Operating Income (cont.)

LO-2

© 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 4.5

Calculating Number of Units to Be Sold to

Earn A Target Operating Income (cont.)

LO-2

© 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

Sales Revenue to Achieve a Target Income (cont.)

operating income of $37,500 to the $45,000 of

fixed cost and divide by the contribution margin

ratio. This equation is:

LO-2

© 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

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.

LO-2

© 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 4.6

Calculating Sales Needed to

Earn a Target Operating Income

LO-2

© 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 4.6

Calculating Sales Needed to

Earn A Target Operating Income (cont.)

LO-2

© 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

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:

in = Margin x in

Profits Ratio Sales

LO-2

© 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

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

© 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

Cost-Volume-Profit Relationships:

The Profit-Volume Graph

A profit-volume graph visually portrays the

relationship between profits (operating income)

and units sold.

LO-3

© 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

The Cost-Volume-Profit Graph

LO-3

© 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

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

© 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

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?

LO-4

© 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

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.

LO-4

© 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 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

LO-4

© 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.)

LO-4

© 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.)

LO-4

© 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.)

LO-4

© 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 4.8

Break-Even Sales Dollars

for a Multiple-Product Firm (cont.)

LO-4

© 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 4.8

Break-Even Sales Dollars

for a Multiple-Product Firm (cont.)

LO-4

© 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

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??

LO-5

© 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

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.

LO-5

© 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

Methods to Deal with

Uncertainty and Risk

LO-5

© 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

Margin of Safety and

Operating Leverage

LO-5

© 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

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:

LO-5

© 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

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%

LO-5

© 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 4.9

Computing the Margin of Safety

LO-5

© 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

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.

LO-5

© 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

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

LO-5

© 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 4.10

Computing the Degree of

Operating Leverage

LO-5

© 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 4.10

Computing the Degree of

Operating Leverage (cont.)

LO-5

© 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

Summary of Operating Leverage

Operating Leverage

HIGH LOW

% profit increase with sales Large Small

increase

decrease

LO-5

© 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

Sensitivity Analysis

LO-5

© 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

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