Cost-Volume-Profit Analysis

Chapter 3

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2009 Foster Business School Cost Accounting L.DuCharme
 Outline

• CVP assumptions & terminology

• BEP solution
– Target operating income
– Target net income
• Margin of Safety
• Operating Leverage
• CM vs. GM
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2009 Foster Business School Cost Accounting L.DuCharme
 Assumptions

Four assumptions
underlying cost-volume-profit
(CVP) analysis are presented
in the text.
We will assume that they hold here.

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2009 Foster Business School Cost Accounting L.DuCharme
 Cost-Volume-Profit Terminology

Operating income
= Total revenues from operations
– Cost of goods sold and operating costs
(excluding income taxes)
Net income = Operating income – Income taxes

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2009 Foster Business School Cost Accounting L.DuCharme
 (CVP) Analysis Example

Assume that the Pants Shop can purchase pants

for $32 from a local factory; other variable costs
amount to $10 per unit.
The local factory allows the Pants Shop to
return all unsold pants and receive a full $32
refund per pair of pants within one year.
The average selling price per pair of pants is $70
and total fixed costs amount to $84,000.
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2009 Foster Business School Cost Accounting L.DuCharme
 (CVP) Analysis Example

How much revenue will the business receive if

2,500 units are sold?
2,500 × $70 = $175,000
How much variable costs will the business incur?
2,500 × $42 = $105,000
$175,000 – 105,000 – 84,000 = ($14,000)
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2009 Foster Business School Cost Accounting L.DuCharme
 (CVP) Analysis Example

What is the contribution margin per unit?

$70 – $42 = $28 contribution margin per unit
What is the total contribution margin when
2,500 pairs of pants are sold?
2,500 × $28 = $70,000

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2009 Foster Business School Cost Accounting L.DuCharme
 (CVP) Analysis Example

Contribution margin percentage (contribution

margin ratio) is the contribution margin per
unit divided by the selling price.
What is the contribution margin percentage?
$28 ÷ $70 = 40%

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2009 Foster Business School Cost Accounting L.DuCharme
 (CVP) Analysis Example

If the business sells 3,000 pairs of pants,

revenues will be $210,000 and contribution
margin would equal 40% × $210,000 = $84,000.

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2009 Foster Business School Cost Accounting L.DuCharme
 BEPs

Determine the breakeven point

and output level needed to achieve
a target operating income using:
(1) the equation,
(2) contribution margin, and
(3) graph methods.
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2009 Foster Business School Cost Accounting L.DuCharme
 Breakeven Point

Variable Fixed
Sales – expenses = expenses

Total revenues = Total costs

Rev – VC – FC = 0

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2009 Foster Business School Cost Accounting L.DuCharme
 Abbreviations

SP = Selling price
VCU = Variable cost per unit
CMU = Contribution margin per unit
CM% = Contribution margin percentage
FC = Fixed costs

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2009 Foster Business School Cost Accounting L.DuCharme
 Abbreviations

Q = Quantity of output units sold

(and manufactured)
OI = Operating income
TOI = Target operating income
TNI = Target net income (after tax)

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2009 Foster Business School Cost Accounting L.DuCharme
 Equation Method

(Selling price × Quantity sold) – (Variable unit cost

× Quantity sold) – Fixed costs = Operating income
Let Q = number of units to be sold to break even
$70Q – $42Q – $84,000 = 0
$28Q = $84,000
Q = $84,000 ÷ $28 = 3,000 units

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2009 Foster Business School Cost Accounting L.DuCharme
 Contribution Margin Method

$84,000 ÷ $28 = 3,000 units

$84,000 ÷ 40% = $210,000

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2009 Foster Business School Cost Accounting L.DuCharme
 Graph Method

Breakeven
378
336 e
294 en u
Rev
252 osts
$(000)

l c
210 Tota
168
126 Fixed costs
84
42
0
0 1000 2000 3000 4000 5000
Units
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2009 Foster Business School Cost Accounting L.DuCharme
 Target Operating Income

(Fixed costs + Target operating income)

divided either by Contribution Margin
percentage or Contribution Margin per unit

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2009 Foster Business School Cost Accounting L.DuCharme
 Target Operating Income

Assume that management wants to have an

operating income of $14,000.
How many pairs of pants must be sold?
($84,000 + $14,000) ÷ $28 = 3,500
What dollar sales are needed to achieve this income?
($84,000 + $14,000) ÷ 40% = $245,000
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2009 Foster Business School Cost Accounting L.DuCharme
 Income Taxes

Understand how income

taxes affect CVP analysis.

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2009 Foster Business School Cost Accounting L.DuCharme
 Target Net Income
and Income Taxes Example
Management would like to earn
an after tax income of $35,711.
The tax rate is 30%.
What is the target operating income?
Target operating income
= Target net income ÷ (1 – tax rate)
TOI = $35,711 ÷ (1 – 0.30) = $51,016
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2009 Foster Business School Cost Accounting L.DuCharme
 Target Net Income
and Income Taxes Example

How many units must be sold?

Revenues – Variable costs – Fixed costs
= Target net income ÷ (1 – tax rate)
$70Q – $42Q – $84,000 = $35,711 ÷ 0.70
$28Q = $51,016 + $84,000
Q = $135,016 ÷ $28 = 4,822 pairs of pants
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2009 Foster Business School Cost Accounting L.DuCharme
 Target Net Income
and Income Taxes Example
Proof:
Revenues: 4,822 × $70 $337,540
Variable costs: 4,822 × $42 202,524
Contribution margin $135,016
Fixed costs 84,000
Operating income 51,016
Income taxes: $51,016 × 30% 15,305
Net income $ 35,711
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2009 Foster Business School Cost Accounting L.DuCharme
 Margin of Safety (MoS)

Margin of Safety = Revenues* – BEP

(*Revenues are either budgeted or actual.)

MoS can either be expressed in # of units or

$.

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2009 Foster Business School Cost Accounting L.DuCharme
 MoS--question

Brie Soda has sales of $200,000; a CM of

20%; and a margin of safety of $80,000.
What is Brie’s fixed cost?
A. $16,000
B. $24,000
C. $80,000
D. $96,000
E. None of the above
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2009 Foster Business School Cost Accounting L.DuCharme
 Operating Leverage

Operating leverage describes the effects that

fixed costs have on changes in operating
income as changes occur in units sold.

Organizations with a high proportion of fixed

costs have high operating leverage.

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2009 Foster Business School Cost Accounting L.DuCharme
 Operating Leverage Example

Degree of operating leverage

= Contribution margin ÷ Operating income
What is the degree of operating leverage
of the Pants Shop at the 3,500 sales level
under two different arrangements?
Existing arrangement:
3,500 × $28 = $98,000 contribution margin
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2009 Foster Business School Cost Accounting L.DuCharme
 Operating Leverage Example

$98,000 contribution margin – $84,000 fixed costs

= $14,000 operating income
$98,000 ÷ $14,000 = 7.0

New arrangement:
Assume Unit Variable Costs = $35 and Fixed Cost = $114,000
3,500 × $35 = $122,500 contribution margin

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2009 Foster Business School Cost Accounting L.DuCharme
 Operating Leverage Example

$122,500 contribution margin

– $114,000 fixed costs = $8,500
$122,500 ÷ $8,500 = 14.4
The degree of operating leverage at a given level
of sales helps managers calculate the effect of
fluctuations in sales on operating income.
E.g., above: a 10% increase in sales will yield a 144% increase in op. income!
What is operating leverage if fixed costs = 0?
As sales increase, what happens to op. leverage?
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2009 Foster Business School Cost Accounting L.DuCharme
 Contribution Margin versus
Gross Margin

Contribution income statement emphasizes

contribution margin.
Financial accounting income statement
emphasizes gross margin.

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2009 Foster Business School Cost Accounting L.DuCharme
 GM versus CM

• The difference between GM and CM all is

in how you account for:
– Fixed mfg. costs (in CoGS, NOT in VC)
– Variable non-mfg. costs (in VC, NOT in CoGS)

GM = Rev. – CoGS
CM = Rev. – VC
“Margins” are usually referred to in finance. What margins are they usually referring to?

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2009 Foster Business School Cost Accounting L.DuCharme
 End of Chapter 3

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2009 Foster Business School Cost Accounting L.DuCharme