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Accounting and Financial Management

Cost Volume Profit Analysis

1
Cost-Volume-Profit Analysis
CVP
CVP analysis
analysis is is used
used toto answer
answer questions
questions
such
such as: as:
 How
 How much much mustmust II sell
sell to
to earn
earn my
my desired
desired income?
income?
 How
 How will will income
income bebe affected
affected
ifif II reduce
reduce selling
selling prices
prices toto
increase
increase sales sales volume?
volume?
 What
 What will will happen
happen to to
profitability
profitability ifif II expand
expand
capacity?
capacity?

CP 2
Total Fixed Cost

Total fixed costs remain unchanged


when activity changes.
Telephone Bill
Monthly Basic

Your monthly basic


telephone bill probably
does not change when
Number of Local Calls you make more local calls.
CP 3
Fixed Cost Per Unit

Fixed costs per unit decline as activity increases.

Monthly Basic Telephone


Bill per Local Call
Your average cost per
local call decreases as
more local calls are made.
Number of Local Calls
CP 4
Total Variable Cost

Total variable costs change when activity


changes.
Total Long Distance
Telephone Bill

Your total long distance


telephone bill is based
on how many minutes
Minutes Talked you talk.
CP 5
Variable Cost Per Unit

Variable costs per unit do not change


as activity increases.

Telephone Charge
The cost per long distance Per Minute
minute talked is constant.
For example, 10
cents per minute. Minutes Talked
CP 6
Cost Behavior Summary

Summary of Variable and Fixed Cost Behavior


Cost In Total Per Unit

Changes as activity level Remains the same over wide


Variable
changes. ranges of activity.
Remains the same even Dereases as activity level
Fixed
when activity level changes. increases.

CP 7
Mixed Costs

Mixed costs contain a fixed portion that is incurred even when


facility is unused, and a variable portion that increases with
usage.

Example: monthly electric utility charge


 Fixed service fee
 Variable charge per
kilowatt hour used

CP 8
Mixed Costs

Slope is
variable cost
per unit
of activity.
Total Utility Cost

ost
edc Variable
mix
tal Utility Charge
To

Fixed Monthly
Utility Charge
Activity (Kilowatt Hours)
CP 9
Stair-Step Costs

Total cost remains


constant within a
narrow range of
activity.

Cost
Activity
CP 10
Stair-Step Costs

Total cost increases to a


new higher cost for the
next higher range of
activity.

Cost
Activity
CP 11
Cost-Volume-Profit CVP) Analysis

Let’s extend our


knowledge of
cost behavior to
CVP analysis.

CP 12
Computing Break-Even Point

The break-even point (expressed in units of


product or dollars of sales) is the unique
sales level at which a company neither
earns a profit nor incurs a loss.

CP 13
Computing Break-Even Point

Total Unit
Sales Revenue (2,000 units) $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Operating income $ 10,000

How
How
How
How much
How
many
much
many
How much contribution
many
units
units
Contribution
How much mustmargin
units
must
contribution
Contribution margin
contribution
margin
contribution ismust
this
margin
is must
amount
this
margin
amount
margin bythis
this
company
must
by
company
must
mustthis company
company
whichsell
company
this
which
this to
revenue
sell have
to cover
have
cover
company
revenue
company
exceeds
exceedsto
haveto
havethecover
cover
to
its
theto its
variable
cover
fixed
variable
cover fixed
its its
fixed
costs
costsfixed
costs
its costs
costs
fixed of (break
(break
producing
costs
(break
of (breakeven)?
even)?
even)?
producing
costs (break the revenue.
even)?
the revenue.
even)?
its fixed costs (break
sell to cover its fixed costs even)?
Answer: $30,000
Answer:even)?
$30,000
CP Answer: (break
Answer: $30,000 ÷ $20 per
$30,000 ÷ $20 per unit
unit == 1,500
14 1,500 units
units
Formula for Computing Break-Even Sales (in Units)
Finding the Break-Even Point
We have just seen one of the basic CVP relationships – the
break-even computation.

Fixed costs
Break-even point in units =
Contribution margin per unit

Unit sales price less unit variable cost


($20 in previous example)

CP 15
Formula for Computing
Break-Even Sales (in Dollars)

The break-even formula may also be


expressed in sales dollars.

Fixed costs
Break-even point in dollars =
Contribution margin ratio

Unit sales price - Unit variable cost


Unit sales price
CP 16
Computing Break-Even Sales

ABC
ABC Co.
Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit. IfIf fixed
fixed costs
costs are
are $200,000
$200,000
and
and variable
variable costs
costs are
are $3.00
$3.00 per
per unit,
unit, how
how many
many unitsunits must
must be
be sold
sold to
to
break
break even?
even?

a.
a. 100,000
100,000 units
units
b.
b. 40,000
40,000 units
units
c.
c. 200,000
200,000 units
units
d.
d. 66,667
66,667 units
units

CP 17
Computing Break-Even Sales

ABC
ABC Co.
Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit. IfIf fixed
fixed costs
costs are
are $200,000
$200,000
and
and variable
variable costs
costs are
are $3.00
$3.00 per
per unit,
unit, how
how many
many unitsunits must
must be
be sold
sold to
to
break
break even?
even?

a.
a. 100,000
100,000 units
units
b.
b. 40,000
40,000 units
units
c.
c. 200,000
200,000 units
units
d.
d. 66,667
66,667 units
units
Unit contribution = $5.00 - $3.00 = $2.00
Fixed costs $200,000
= $2.00 per unit
Unit contribution

CP 18
= 100,000 units
Computing Break-Even Sales

Use
Use the
the contribution
contribution margin
margin ratio
ratio formula
formula toto
determine
determine the
the amount
amount ofof sales
sales revenue
revenue ABCABC must
must
have
have to
to break
break even.
even. All
All information
information remains
remains
unchanged:
unchanged: fixed
fixed costs
costs are
are $200,000;
$200,000; unit
unit sales
sales
price
price is
is $5.00;
$5.00; and
and unit
unit variable
variable cost
cost is
is $3.00.
$3.00.

a.
a. $200,000
$200,000
b.
b. $300,000
$300,000
c.
c. $400,000
$400,000
d.
d. $500,000
$500,000
CP 19
Computing Break-Even Sales

Use
Use the
the contribution
contribution margin
margin ratio
ratio formula
formula toto
determine
determine the
the amount
amount ofof sales
sales revenue
revenue ABCABC must
must
have
have to
to break
break even.
even. All
All information
information remains
remains
unchanged:
unchanged: fixed
fixed costs
costs are
are $200,000;
$200,000; unit
unit sales
sales
price
price is
is $5.00;
$5.00; and
and unit
unit variable
variable cost
cost is
is $3.00.
$3.00.
Unit contribution = $5.00 - $3.00 = $2.00
a.
a. $200,000
$200,000
Contribution margin ratio = $2.00 ÷ $5.00 = .40
b.
b. $300,000
$300,000
Break-even revenue = $200,000 ÷ .4 = $500,000
c.
c. $400,000
$400,000
d.
d. $500,000
$500,000
CP 20
Preparing a CVP Graph

 Starting at the origin, draw the total revenue


line with a slope equal to the unit sales price. Revenue
Costs and Revenue
in Dollars

 Total fixed cost


extends horizontally
from the vertical axis.

Total fixed cost


CP Volume
21 in Units
Preparing a CVP Graph
Revenue
 Draw the total cost line with a slope
equal to the unit variable cost.
Costs and Revenue

Break-even
Profit
Point
in Dollars

Total cost

Loss
Total fixed cost

CP Volume
22 in Units
Computing Sales Needed to Achieve
Target Operating Income

Break-even
Break-even formulas
formulas may
may be
be adjusted
adjusted to
to show
show the
the sales
sales
volume
volume needed
needed toto earn
earn
any
any amount
amount of
of operating
operating income.
income.

Fixed costs + Target income


Unit sales =
Contribution margin per unit

Fixed costs + Target income


Dollar sales =
Contribution margin ratio
CP 23
Computing Sales Needed to Achieve
Target Operating Income

ABC
ABC Co.
Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit. IfIf
fixed
fixed costs
costs are
are $200,000
$200,000 and
and variable
variable costs
costs
are
are $3.00
$3.00 per
per unit,
unit, how
how many
many units
units must
must bebe
sold
sold to
to earn
earn operating
operating income
income ofof $40,000?
$40,000?

a.
a. 100,000
100,000 units
units
b.
b. 120,000
120,000 units
units
c.
c. 80,000
80,000 units
units
d.
d. 200,000
200,000 units
units
CP 24
Computing Sales Needed to Achieve
Target Operating Income

ABC
ABC Co.
Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit. IfIf
fixed
fixed costs
costs are
are $200,000
$200,000 and
and variable
variable costs
costs
are
are $3.00
$3.00 per
per unit,
unit, how
how many
many units
units must
must bebe
sold
sold to
to earn
earn operating
operating income
income ofof $40,000?
$40,000?

Unit contribution = $5.00 - $3.00 = $2.00


a.
a. 100,000 units
100,000 units
Fixed costs + Target income
b.
b. 120,000 units
120,000 units Unit contribution
c.
c. 80,000
80,000 units
units
$200,000 + $40,000
= 120,000 units
d.
d. 200,000 units
200,000 units $2.00 per unit
CP 25
What is our Margin of Safety?

Margin of safety is the amount by which sales may decline


before reaching break-even sales:

Margin of safety = Actual sales - Break-even sales

Margin of safety provides a quick means of estimating


operating income at any level of sales:

Operating Margin Contribution


Income = of safety × margin ratio
CP 26
What is our Margin of Safety?

ADM contribution margin ratio is 40 percent. If sales are


$100,000 and break-even sales are $80,000, what is
operating income?

Operating Margin Contribution


Income = of safety × margin ratio

Operating
Income = $20,000 × .40 = $8,000

CP 27
What Change in Operating Income Do We
Anticipate?
Once break-even is reached, every additional dollar of contribution margin
becomes operating income:

Change in Change in Contribution


operating income = sales volume × margin ratio

ADM expects sales to increase by $15,000 and has a contribution margin


ratio of 40%. How much will operating income increase?

Change in
operating income = $15,000 × .40 = $6,000

CP 28
Business Applications of CVP

Consider the following information developed by the


accountant at Speedo, a bicycle retailer:

Total Per Unit Percent


Sales (500 bikes) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000
Operating income $ 20,000

CP 29
Business Applications of CVP

Should Speedo spend $12,000 on advertising to increase


sales by 10 percent?

Total Per Unit Percent


Sales (500 bikes) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000
Operating income $ 20,000

CP 30
Business Applications of CVP

Should Speedo spend $12,000 on advertising to increase


sales by 10 percent?

500 550
550 × $500
Bikes Bikes
Sales $ 250,000 $ 275,000
Less: variable expenses 150,000 550 × $300 165,000
Contribution margin $ 100,000 $ 110,000
Less: fixed expenses 80,000 92,000
Operating income $ 20,000 $80K + $12K $ 18,000

No, income is decreased.

CP 31
Business Applications of CVP

Now, in combination with the advertising,


Speedo is considering a 10 percent price reduction that will
increase sales by 25 percent. What is the income effect?
500
Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin $ 100,000
Less: fixed expenses 80,000
Operating income $ 20,000

CP 32
Business Applications of CVP

Now, in combination with the advertising,


Speedo is considering a 10 percent price reduction that will
increase sales by 25 percent. What is the income effect?
500 1.25 × 500 625
Bikes Bikes
Sales $ 250,000 625 × $450 $ 281,250
Less: variable expenses 150,000 187,500
Contribution margin $ 100,000 625 × $300 $ 93,750
Less: fixed expenses 80,000 92,000
Operating income $ 20,000 $80K + $12K $ 1,750

Income is decreased even more.

CP 33
Business Applications of CVP
Now, in combination with advertising and a price cut, Speedo
will replace $50,000 in sales salaries with a $25 per bike
commission, increasing sales by 50 percent above the
original 500 bikes. What is the effect on income?
500
Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin $ 100,000
Less: fixed expenses 80,000
Operating income $ 20,000

CP 34
Business Applications of CVP
Now, in combination with advertising and a price cut, Speedo
will replace $50,000 in sales salaries with a $25 per bike
commission, increasing sales by 50 percent above the
original 500 bikes. What is the effect on income?
500 1.5 × 500 750
Bikes Bikes
Sales $ 250,000 750 × $450 $ 337,500
Less: variable expenses 150,000 243,750
Contribution margin $ 100,000 750 × $325 $ 93,750
Less: fixed expenses 80,000 42,000
Operating income $ 20,000 $92K - $50K $ 51,750

The combination of advertising, a price cut,


and change in compensation increases income.
CP 35
Additional Considerations in CVP

 Different products with


different contribution margins.

 Determining semivariable
cost elements.

 Complying with the


assumptions of CVP analysis.
CP 36
CVP Analysis When a Company Sells
Many Products

Sales
Sales mix
mix is
is the
the relative
relative combination
combination in
in which
which
aa company’s
company’s different
different products
products are
are sold.
sold.
Different
Different products
products have
have different
different selling
selling prices,
prices, costs,
costs, and
and
contribution
contribution margins.
margins.
IfIf Speedo
Speedo sells
sells bikes
bikes and
and carts,
carts, how
how
will
will we
we deal
deal with
with break-even
break-even analysis?
analysis?

CP 37
CVP Analysis When a Company Sells
Many Products

Speedo provides us with the following information:

Bikes Carts Total


Sales $ 250,000 100% $ 300,000 100% $ 550,000 100%
Var. exp. 150,000 60% 135,000 45% 285,000 52%
Contrib. margin $ 100,000 40% $ 165,000 55% $ 265,000 48%
Fixed exp. 170,000
Net income $ 95,000

CP 38
CVP Analysis When a Company Sells
Many Products

The overall contribution margin ratio is:

Bikes Carts Total


Sales $ 250,000 100% $ 300,000 100% $ 550,000 100%
Var. exp. 150,000 60% 135,000 45% 285,000 52%
Contrib. margin $ 100,000 40% $ 165,000 55% $ 265,000 48%
Fixed exp. 170,000
Net income $ 95,000

$265,000
= 48% (rounded)
$550,000
CP 39
CVP Analysis When a Company Sells
Many Products

Break-even in sales dollars is:

Bikes Carts Total


Sales $ 250,000 100% $ 300,000 100% $ 550,000 100%
Var. exp. 150,000 60% 135,000 45% 285,000 52%
Contrib. margin $ 100,000 40% $ 165,000 55% $ 265,000 48%
Fixed exp. 170,000
Operating income $ 95,000

$170,000
= $354,167 (rounded)
.48
CP 40
The High-Low Method

Matrix, Inc. recorded the following production activity and maintenance


costs for two months:
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600
Using these two levels of activity, compute:
 the variable cost per unit.
 the total fixed cost.
 total cost formula.

CP 41
The High-Low Method

Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

∆ in cost $3,600
 Unit variable cost = ∆ in units= 4,000 = $0.90 per unit

CP 42
The High-Low Method

Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

∆ in cost $3,600
 Unit variable cost = ∆ in units= 4,000 = $0.90 per unit
 Fixed cost = Total cost – Total variable cost

CP 43
The High-Low Method

Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

∆ in cost $3,600
 Unit variable cost = ∆ in units= 4,000 = $0.90 per unit
 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)
Fixed cost = $9,700 – $8,100 = $1,600

CP 44
The High-Low Method

Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

∆ in cost $3,600
 Unit variable cost = ∆ in units= 4,000 = $0.90 per unit
 Fixed cost = Total cost – Total variable cost
Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)
Fixed cost = $9,700 – $8,100 = $1,600
 Total cost = $1,600 + $.90 per unit
CP 45
The High-Low Method

IfIf sales
sales commissions
commissions areare $10,000
$10,000 when
when 80,000
80,000 units
units are
are
sold
sold and
and $14,000
$14,000 when
when 120,000
120,000 units
units are
are sold,
sold, what
what is
is
the
the variable
variable portion
portion of
of sales
sales commission
commission per
per unit
unit sold?
sold?

a.
a. $.08
$.08 per
per unit
unit
b.
b. $.10
$.10 per
per unit
unit
c.
c. $.12
$.12 per
per unit
unit
d.
d. $.125
$.125 per
per unit
unit

CP 46
The High-Low Method

IfIf sales
sales commissions
commissions areare $10,000
$10,000 when
when 80,000
80,000 units
units are
are
sold
sold and
and $14,000
$14,000 when
when 120,000
120,000 units
units are
are sold,
sold, what
what is
is
the
the variable
variable portion
portion of
of sales
sales commission
commission per
per unit
unit sold?
sold?

a.
a. $.08
$.08 per
per unit
unit
b.
b. $.10
$.10 per
per unit
unit Units Cost
High level 120,000 $ 14,000
c.
c. $.12
$.12 per
per unit
unit
Low level 80,000 10,000
d.
d. $.125
$.125 per
per unit
unit Change 40,000 $ 4,000

$4,000 ÷ 40,000 units


= $.10 per unit
CP 47
The High-Low Method

IfIf sales
sales commissions
commissions are are $10,000
$10,000 when
when 80,000
80,000 units
units
are
are sold
sold and
and $14,000
$14,000 when
when 120,000
120,000 units
units are
are sold,
sold,
what
what is
is the
the fixed
fixed portion
portion of
of the
the sales
sales commission?
commission?
a.
a. $$ 2,000
2,000
b.
b. $$ 4,000
4,000
c.
c. $10,000
$10,000
d.
d. $12,000
$12,000

CP 48
The High-Low Method

IfIf sales
sales commissions
commissions are are $10,000
$10,000 when
when 80,000
80,000 units
units
are
are sold
sold and
and $14,000
$14,000 when
when 120,000
120,000 units
units are
are sold,
sold,
what
what is
is the
the fixed
fixed portion
portion of
of the
the sales
sales commission?
commission?
a.
a. $$ 2,000
2,000
Total cost = Total fixed cost +
b.
b. $$ 4,000
4,000 Total variable cost
c.
c. $10,000
$10,000 $14,000 = Total fixed cost +
d.
d. $12,000
$12,000 ($.10 × 120,000 units)
Total fixed cost = $14,000 - $12,000
Total fixed cost = $2,000

CP 49
Assumptions Underlying
CVP Analysis

 A limited range of activity, called the relevant


range, where CVP relationships are linear.
 Unit selling price remains constant.
 Unit variable costs remain constant.
 Total fixed costs remain constant.
 Sales mix remains constant.
 Production = sales (no inventory changes).

CP 50