Chapter 22

Cost-Volume-Profit Analysis

Cost-Volume-Profit Analysis

 a. b. c.

d. e.

CVP analysis is a technique for studying the relationship between cost, volume and profits. Examines the behavior of total revenues, total costs, and operating income as changes occur in the output level, selling price, variable costs or fixed cost It can be used to answer the questions like: How much sales should be made to avoid the losses? How much should be the sales to earn a desired profit? What will be the effect of change in prices, costs and volume on profits Which product or product mix is most profitable? Should we manufacture or buy some product or component?

Page 67

Assumptions of CVP Analysis
  

       

Expenses can be classified as either variable or fixed. CVP relationships are linear over a wide range of production and sales. Sales prices, unit variable cost, and total fixed expenses will not vary within the relevant range. Volume is the only cost driver. The relevant range of volume is specified. Inventory levels will be unchanged. The sales mix remains unchanged during the period. revenues change in relation to production and sales costs and prices are known if more than one product exists, the sales mix is constant we can ignore the time value of money

Objectives
  

Identify how changes in volume affect costs. Use CVP analysis to compute breakeven point. Use CVP analysis for profit planning and graph the cost-volume-profit relations Use CVP method to perform sensitivity analysis.

Contribution Margin

Contribution margin is equal to the difference between total revenue and total variable costs

Contribution margin per unit = Selling price - Variable cost per unit Contribution margin percentage = Contribution margin per unit / selling price per unit

Total for Per Unit 2 units

%

Revenue Variable costs Contribution margin

200400 120240 80160

100% 60% 40%
Pages 68 - 69

Contribution Margin Income Statement
Sales - Variable Costs Contribution Margin - Fixed Costs Operating Income Sales (20,000 x 85) 1,700,000 Variable costs (20,000 x 70) (1,400,000) Contribution margin 300,000

Contribution Margin Income Statement

Income statement that groups line items by cost behavior to highlight the contribution margin

Packages Sold

0 Revenue Variable costs Contribution margin Fixed costs

12

2540

0200 4005,0008,000 0120 2403,0004,800 080 1602,0003,200 01,200
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2,0002,0002,000 2,0002,000

Operating income (2,000)(1,920)(1,840)

Computing Break-Even Point
The unique sales level at which a company earns neither a profit nor incurs a loss.
Sales – Variable Costs – Fixed Costs = 0

Breakeven Point
 

Quantity of output where total revenues equal total costs Point where operating income equals zero

Breakeven point in units = Fixed costs / Contribution margin per unit = 2,000 / 80 = 25 units Breakeven point in Rupees = Fixed costs / contribution margin % = 2,000 / 40% = 5,000 RS.
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Margin Of Safety

Excess of actual or budgeted sales over the break – even sales is known as MOS

MOS = Total Sales - sales at BEP It can be improved by taking the following steps: 1. By increasing the level of production or selling price 2. By reducing fixed or variable cost.

Angle of Incidence

Is the angle between the sales line and the total cost line formed at the break even point where the sales line and the total cost line intersects each other. It indicates the profit earning capacity of a business. A Large angle of incidence indicate a high rate of profit and a small angle of incidence indicates a low rate of profit

Types of Costs
Variable Fixed Mixed

Total Variable Cost
Total Long Distance Telephone Bill

Total variable costs change when activity changes.
Your total long distance telephone bill is based on how many minutes you talk.

Minutes Talked

Variable Cost Per Unit
Variable costs per unit do not change as activity increases.
Per Minute Telephone Charge
Minutes Talked

The cost per long distance minute talked is constant. For example, 2 Rs. per minute.

Total Fixed Cost
Total fixed costs remain unchanged when activity changes.
Monthly Basic Telephone Bill
Number of Local Calls

Variable Costs Example
24 – 18 – 12 –
a r a Vl at o T i ) s dnas uo h ( t

6 –

0

Volume (Thousands of passengers)

1

2

3

4

5

Mixed Costs

Contain fixed portion that is incurred even when facility is unused & variable portion that increases with usage. Example: monthly electric utility charge
 

Fixed service fee Variable charge per kilowatt hour used

Mixed Costs
Total Utility Cost

t os dc i xe m al ot T

Variable Utility Charge Fixed Monthly Utility Charge

Activity (Kilowatt Hours)

Preparing a CVP Chart
– Plot total fixed costs on the vertical axis.
Costs and Revenue in Dollars

Total fixed costs

Total costs

Draw the total cost line with a slope equal to the unit variable cost.

Volume in Units

Preparing a CVP Chart
Starting at the origin, draw the sales line with a slope equal to the unit sales price.

Sales

Costs and Revenue in Dollars

Total fixed costs

Total costs Break-even Point

Volume in Units

Various Sales Levels Example

What operating income is expected when sales are 80,000 units?

Selling price (20/unit) 16,00,000 Less: Variable exp (10/unit) 8,00,000 Contribution 8,00,000 Less: Fixed cost 4,00,000 Operating profit 4,00,000

Computing Multiproduct Break-Even Point

Unit contribution margin is replaced with contribution margin for a composite unit. A composite unit is composed of specific numbers of each product in proportion to the product sales mix. Sales mix is the ratio of the volumes of the various products.

Computing Multiproduct Break-Even Point
The resulting break-even formula for composite unit sales is:

Break-even point in composite units

=

Fixed costs Contribution margin per composite unit

Computing Multiproduct Break-Even Point
Step 2: Compute break-even point in composite units.
Break-even point in composite units Break-even point in composite units Break-even point in composite units = Fixed costs Contribution margin per composite unit 900,000 450 per composite unit 2,000 composite units

=

=

Computing Multiproduct Break-Even Point
A company sells windows and doors. They sell 4 windows for every door.
Windows Doors $200 $500 125 350 $ 75 $ 150 4 1

Selling Price Variable Cost Unit Contribution Sales Mix Ratio

Computing Multiproduct Break-Even Point
Step 1: Compute contribution margin per composite unit.
Selling Price Variable Cost Unit Contribution Sales Mix Ratio Composite C/M Windows Doors $200 $500 125 350 $ 75 $ 150

Computing Multiproduct Break-Even Point
Step 3: Determine the number of windows and doors that must be sold to break even.
Sales Composite Product Mix Units Window 4 × 2,000 = Door 1 × 2,000 =

Units 8,000 2,000

Multiproduct Break-Even Income Statement
Step 4: Verify the results.
W indow s Se lling Price $200 Va ria ble Cost 125.00 Unit Contribution $ 75.00 Sa le s Volum e × 8,000 Tota l Contribution $ 600,000 Fix e d Costs Incom e Doors $500 350.00 $ 150.00 × 2,000 $ 300,000 Com bine d

$ 900,000 900,000 $ 0

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