Accounting Chapter 15 - CVP Analysis

Chapter 15 - CVP Analysis

• Chapter Objectives: Students should be able to explain the difference between contribution (variable) income statements and functional (GAAP) income statements, discuss and calculate Contribution Margin, identify assumptions needed for CVP analysis, use the CVP model to calculate break-even point, margin of safety, and define operating leverage and apply operating leverage ratio.

Income Statement Formats

• Contribution Income Statement: Classifies costs by behavior (variable or fixed). Contribution margin is calculated by subtracting total variable costs from total revenues. This margin is used to cover fixed costs and generate profit.
• Functional (GAAP) Income Statement: Classifies costs by function (manufacturing, selling, administrative). Gross margin is calculated by subtracting the cost of goods sold from total revenues. This margin is used to cover all other expenses and generate profit.

Example

• Chillin' Time: Produces and sells one product (ice cream bars) at $1.50 each. No inventories are maintained.
• Variable Costs Per Ice Cream Bar: Direct materials (0.43),directlabor(0.43), direct labor (0.43),directlabor(0.32), manufacturing overhead (0.20),sellingandadministrative(0.20), selling and administrative (0.20),sellingandadministrative(0.15) totaling $1.10 per bar.
• Fixed Costs Per Month: Manufacturing overhead (1,200),sellingandadministrative(1,200), selling and administrative (1,200),sellingandadministrative(580), totaling $1,780.

Functional Income Statement Example (Chillin' Time)

• Sales (6,950 bars x 1.50)=1.50) = 1.50)=10,425
• Less Cost of Goods Sold: Direct materials (2,988),directlabor(2,988), direct labor (2,988),directlabor(2,224), variable manufacturing overhead (1,390),fixedmanufacturingoverhead(1,390), fixed manufacturing overhead (1,390),fixedmanufacturingoverhead(1,200) = $7,802
• Gross Margin: $2,623
• Less Other Expenses: Variable selling and administrative (1,043),fixedsellingandadministrative(1,043), fixed selling and administrative (1,043),fixedsellingandadministrative(580) = $1,623
• Profit: $1,000

Contribution (Variable) Income Statement Example (Chillin' Time)

• Sales (6,950 bars x 1.50)=1.50) = 1.50)=10,425
• Less Variable Costs: Direct materials (2,988),directlabor(2,988), direct labor (2,988),directlabor(2,224), manufacturing overhead (1,390),sellingandadministrative(1,390), selling and administrative (1,390),sellingandadministrative(1,043) = $7,645
• Contribution Margin: $2,780
• Less Fixed Costs: Manufacturing (1,200),sellingandadministrative(1,200), selling and administrative (1,200),sellingandadministrative(580) = $1,780
• Profit: $1,000

Contribution Margin Calculations

• Total Sales: $10,425
• Total Variable Costs: $7,645
• Contribution Margin: $2,780
• Contribution Margin Per Unit: $.40
• Contribution Margin Ratio: 26.7%

Cost-Volume-Profit Analysis (CVP)

• A technique to analyze the relationship between volume, costs, revenues, and profits during a specific period. CVP is useful in early planning stages. Provides a simple framework for discussing planning issues and organizing relevant data
• Assumptions: All costs are either fixed or variable, total cost function is linear within the relevant range, total revenue function is linear within the relevant range, the analysis is for a single product or a constant sales mix of multiple products.

CVP Model Applications

• How many cappuccinos must Starbucks sell to earn a $50,000 profit?
• At what sales volume will McDonald's total revenues and costs be equal (break-even)?
• What profit will Office Max earn at $200 million in sales?
• What happens to Disney's profit when ticket prices increase by 10% and fixed costs increase by 8%?

CVP Assumptions

• All costs are categorized as either fixed or variable.
• The total cost function is linear within the relevant range.
• The total revenue function is linear within the relevant range.
• The analysis is for a single product, or a constant sales mix of multiple products.

Variable and Fixed Components

• Variable Costs: Variable manufacturing costs, variable selling, and administrative costs.
• Fixed Costs: Fixed manufacturing overhead, fixed selling, and administrative costs.

Calculating Target Profit Example

• Chillin' Time wants a monthly profit of 800.Howmanyicecreambarsneedtobesold?6,450.(800. How many ice cream bars need to be sold? 6,450. (800.Howmanyicecreambarsneedtobesold?6,450.(1,780 + 800=800 = 800=2,580 / $0.40 = 6,450)

Break-Even Point in Units

• Break-even point occurs when total revenues equal total costs.
• Formula: Fixed Costs / (Selling Price Per Unit - Variable Costs Per Unit)

Break-Even Point Example

• Chillin' Time sells ice cream bars for 1.50each.Variablecost=1.50 each. Variable cost = 1.50each.Variablecost=1.10 per unit. How many bars must be sold to break even? 4,450 units. (1,780/(1,780 / (1,780/(1.50 - $1.10))

Target Profit Example

• If Chillin' Time wants to earn a monthly profit of 800,howmanyicecreambarsmustitsell?6,450units.((800, how many ice cream bars must it sell? 6,450 units. ((800,howmanyicecreambarsmustitsell?6,450units.((1,780 + 800=800 = 800=2,580 / (1.50−1.50 - 1.50−1.10)) = 6,450)

Net Income Change Examples

• If sales increase by 100 ice cream bars, net income increases by $40.
• If sales increase by 1,050,netincomeincreasesby1,050, net income increases by 1,050,netincomeincreasesby280. (Based on contribution margin ratio).

Cost-Volume-Profit Graph

• Shows the relationship between total costs and total revenues at different sales volume levels. Highlights the break-even point, profit area, and loss area. Depicts total revenue line and total costs line.

Multiple Product Break-Even Point

• Applicable when a company sells more than one product.
• Formula: Fixed Costs / Contribution Margin Per Unit.
• Considers different contribution margins for multiple products.

Sales Mix Analysis

• Sales mix refers to the relative portion of unit or dollar sales derived from different products.
• If sales mix is constant, basic cost-volume-profit model works well.
• If sales mix isn't constant, calculate average unit contribution margin or contribution margin ratio for each mix.

Operating Leverage

• A measure of the extent to which an organization's costs are fixed.
• Formula: Contribution Margin / Income Before Taxes
• High operating leverage = higher profit potential but also risk of large losses with sales decreases.
• Used to evaluate the risk and opportunity of profit increases and losses with sales variations.

Operating Leverage Risk and Opportunity

• High operating leverage = High profit potential with sales increases but high risk of losses with sales decreases.
• Low operating leverage = Low profit potential with sales increases but low risk of losses with sales decreases.

Measuring Expected Change in Profit

• Demonstrates how changes in sales volumes affect profit for companies with different operating leverages.
• Higher operating leverage leads to larger shifts in profits in response to changes in sales volumes.