Chapter 7 Cost-Volume-Profit (CVP) Analysis PDF

Chapter 7: Cost-Volume-Profit (CVP) Analysis 1-1 Cost-Volume-Profit Relationships Cost-volume-profit (CVP) analysis is used to answer questions such as: ▪ How much must I sell to earn my desired income? ▪ How will income be affected if I reduce selli...

Chapter 7: Cost-Volume-Profit (CVP) Analysis 1-1 Cost-Volume-Profit Relationships Cost-volume-profit (CVP) analysis is used to answer questions such as: ▪ How much must I sell to earn my desired income? ▪ How will income be affected if I reduce selling prices to increase sales volume? ▪ What will happen to profitability if I expand capacity? 1-2  Fixed Costs (and Fixed Expenses) Monthly Basic Telephone Bill per Local Call Telephone Bill Monthly Basic Number of Local Calls Number of Local Calls Total fixed costs Cost per call remain constant as declines as activity increases. activity increases. 1-3  Variable Costs (and Variable Expenses) Total Long Distance Cost per Minute Telephone Bill Minutes Talked Minutes Talked Total variable Cost per Minute costs increase as is constant as activity increases. activity increases. 1-4 Semivariable Costs (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 1-5  Semivariable Costs (Mixed Costs) Slope is variable cost per unit of activity. Total Utility Cost Variable Utility Charge Fixed Monthly Utility Charge Activity (Kilowatt Hours) 1-6  CVP Relationships : A Graphical Analysis  Starting at the origin, draw the total revenue line with a slope equal to the unit sales price.  Draw the total cost line Costs and Revenue Break-even Profit with a slope Point equal to the in Dollars unit variable cost.  Total fixed Loss cost extends horizontally from the vertical axis. Volume in Units 1-7 Cost Behavior Summary Summary of Variable and Fixed Cost Behavior Variable Costs Fixed costs Remains the same even Dereases as activity level Per Unit when activity level changes. increases. Changes as activity level Remains the same over wide Total changes. ranges of activity. 1-8 Economies of Scale Economies of scale are most apparent in business with high fixed costs. Utility Oil Steel Companies Refineries Mills Automobile Plant Number Fixed Costs of cars produced Fixed Cost per Month per Month per unit $ 8,400,000 4,000 $ 2,100 8,400,000 6,000 1,400 8,400,000 7,000 1,200 Airlines 1-9 Semivariable Costs Total cost increases to a new higher cost for the next higher range of activity. Cost Total cost remains constant within a narrow range of activity. Activity 1-10  Curvilinear Costs Curvilinear Cost Function Total Cost A straight line closely (constant unit variable cost) approximates a curvilinear variable Relevant Range cost line within the relevant range. Volume of Output 1-11 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. 1-12 Computing Break-Even Point Total Unit Sales Revenue (900 units) $ 81,000 $ 90 Less: Variable costs 32,400 36 Contribution margin $ 48,600 $ 54 Less: Fixed costs 37,800 Operating income $ 10,800 Contribution margin is the amount by which revenue exceeds the variable costs of producing the revenue. How many units must this company sell to cover its fixed costs (break even)? Answer: $37,800 ÷ $54 per unit = 700 units 1-13 How Many Units Must We Sell? We have just seen one of the basic CVP relationships – the break-even computation. Break-even Fixed costs = point in units Contribution margin per unit Unit sales price less unit variable cost ($90 – $36 = $54 in previous example) The units SnowGlide must sell to cover its fixed costs (break even): $37,800 ÷ $54 per unit = 700 units 1-14 Computing Break-Even Units ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to break even? a. 100,000 units b. 40,000 units c. 200,000 units d. 66,667 units 1-15 Computing Break-Even Units ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to break even? a. 100,000 units b. 40,000 units c. 200,000 units Unit contribution = $5.00 - $3.00 = $2.00 d. 66,667 units Fixed Costs $200,000 = Unit contribution $2.00 per unit = 100,000 units 1-16 How Many Dollars in Sales Must We Generate? The break-even formula may also be expressed in sales dollars. Break-even Fixed costs = point in dollars Contribution margin ratio Unit contribution margin Unit sales price The sales SnowGlide must generate to cover its fixed costs (break even): $37,800 ÷ 60%= $63,000 1-17 Computing Break-Even Sales Use the contribution margin ratio formula to determine the amount of sales revenue ABC must have to break even. All information remains unchanged: fixed costs are $200,000; unit sales price is $5.00; and unit variable cost is $3.00. a. $200,000 b. $300,000 c. $400,000 d. $500,000 1-18 Computing Break-Even Sales Use the contribution margin ratio formula to determine the amount of sales revenue ABC must have to break even. All information remains unchanged: fixed costs are $200,000; unit sales price is $5.00; and unit variable cost is $3.00. a. $200,000 Unit contribution = $5.00 - $3.00 = $2.00 Contribution margin ratio = $2.00 ÷ $5.00 =.40 b. $300,000 Break-even revenue = $200,000 ÷.4 = $500,000 c. $400,000 d. $500,000 1-19 Computing Sales Needed to Achieve Target Operating Income Break-even formulas may be adjusted to show the sales volume needed to earn any amount of operating income. Fixed costs + Target income Unit sales = Contribution margin per unit Fixed costs + Target income Dollar sales = Contribution margin ratio 1-20 Computing Sales Needed to Achieve Target Operating Income How many snowboards must SnowGlide sell to earn a $5,400 monthly operating income? Fixed costs + Target income Unit sales = Contribution margin per unit = $37,800 + $5,400 = 800 units per month $54 If SnowGlide would like to earn a $5,400 monthly operating income, what sales volume (in dollars) should be earned? Dollar sales = Fixed costs + Target income Contribution margin ratio $37,800 + $5,400 = = $72,000 per month 60% 1-21 Computing Sales Needed to Achieve Target Operating Income ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to earn operating income of $40,000? a. 100,000 units b. 120,000 units c. 80,000 units d. 200,000 units 1-22 Computing Sales Needed to Achieve Target Operating Income ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to earn operating income of $40,000? Unit contribution = $5.00 - $3.00 = $2.00 a. 100,000 units Fixed costs + Target income b. 120,000 units Unit contribution c. 80,000 units $200,000 + $40,000 d. 200,000 units $2.00 per unit = 120,000 units 1-23 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 For SnowGlide: $9,000 Margin of Safety = $72,000 - $63,000 Margin of safety provides a quick means of estimating operating income at any level of sales: Operating Margin Contribution = × Income of safety margin ratio For SnowGlide: $9,000 x 60% = $5,400 operating income 1-24  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 SnowGlide expects sales to increase by $5,000 and has a contribution margin ratio of 60%. How much will operating income increase? Change in operating income = $5,000 ×.60 = $3,000 1-25 Business Applications of CVP Consider the following information developed by the accountant at SnowGlide, a maker of snowboards: Total Per Unit Percent Sales (900 boards) $ 81,000 $ 90 100% Less: variable expenses 32,400 36 40% Contribution margin $ 48,600 $ 54 60% Less: fixed expenses 37,800 Operating income $ 10,800 1-26 Business Applications of CVP Should SnowGlide spend $1,500 on advertising to increase sales by 500 boards? Total Per Unit Percent Sales (1,400 boards) $126,000 $ 90 100% Less: variable expenses 50,400 36 40% Contribution margin $ 75,600 $ 54 60% Less: fixed expenses 39,300 Operating income $ 36,300 1-27  Business Applications of CVP SnowGlide’s plant manager does not completely agree with the advertising director’s projections. To cope with the increased demand, he asserts that many factory workers will be required to work excessive overtime hours, causing an increase in direct labor costs of approximately $1.80 per unit. Assuming that he is correct, he wants to know the sales volume in units required to achieve the advertising director’s projected monthly income figure of $36,300. New Unit Contribution Margin = Selling Price - Unit Variable Cost = $90.00 - ($36.00 + $1.80) = $52.20 Projected Unit Sales = (Fixed Costs + Target Operating Income) Unit contribution Margin = ($39,300 + $36,300) $52.20 = 1,448 units/month 1-28  Business Applications of CVP The vice president of sales thinks that a more conservative increase of 350 units per month is likely, with the extra overtime. Based on this, how much would SnowGlide have to raise selling prices to achieve a target monthly income figure of $36,300? Projected Unit Sales = Fixed Costs + Target Op. Income Contribution Margin Per unit 1,250 units = $39,300 + $36,300 Contribution Margin per unit Contribution Margin per Unit = $60.48 Unit Contribution Margin = Unit Selling Price - Unit Variable Cost $60.48 = Unit Selling Price - $37.80 Unit Selling Price = $98.28 1-29 Additional Considerations in CVP  Different products with different contribution margins.  Determining semivariable cost elements.  Complying with the assumptions of CVP analysis. 1-30 CVP Analysis When a Company Sells Many Products Sales mix is the relative combination in which a company’s different products are sold. Different products have different selling prices, costs, and contribution margins. If SnowGlide sells snowboards and goggles, how will we deal with break-even analysis? 1-31 CVP Analysis When a Company Sells Many Products SnowGlide provides us with the following information: Product CM Ratio X % of Sales Snowboards 60% X 90% 54% Goggles 80% X 10% 8% Average Contribution Margin Ratio 62% 1-32 Improving the Quality of the Sales Mix  Notice that goggles have a higher contribution margin ratio than snowboards.  A business can improve its average contribution ratio, and its overall profitability, by shifting its sales mix to include more products with high contribution margin ratios. 1-33 Determining Semivariable Cost Elements : The High-Low Method SnowGlide recorded the following production activity and maintenance costs for two months out of the first six months of the year: Units Cost High activity level 950 $ 25,280 Low activity level 850 25,040 Change 100 $ 240 Using these two levels of activity, compute:  the variable cost per unit.  the total fixed cost.  total cost formula. 1-34 Determining Semivariable Cost Elements : The High-Low Method Units Cost High activity level 950 $ 25,280 Low activity level 850 25,040 Change 100 $ 240  Unit variable cost = $240 ÷ 100 units = $2.40 per unit  Fixed cost = Total cost – Total variable cost Fixed cost = $25,280 – ($2.40 × 950 units) Fixed cost = $25,280 – $2,280 = $23,000  Total cost = $23,000 + $2.40 per unit 1-35 The High-Low Method If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales commission per unit sold? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit 1-36 The High-Low Method If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the variable portion of sales commission per unit sold? Units Cost a. $0.08 per unit High level 120,000 $ 14,000 b. $0.10 perLow unitlevel 80,000 10,000 c. $0.12 perChange unit 40,000 $ 4,000 $4,000 ÷ 40,000 units d. $0.125 per unit = $0.10 per unit 1-37 The High-Low Method If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of the sales commission? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 1-38 The High-Low Method If sales commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the fixed portion of the sales commission? a. $ 2,000 b. $ 4,000 Total cost = Total fixed cost + Total variable cost c. $10,000 $14,000 = Total fixed cost + d. $12,000 ($.10 × 120,000 units) Total fixed cost = $14,000 - $12,000 Total fixed cost = $2,000 1-39 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). 1-40 Summary of CVP Relationships 1-41 Ethics, Fraud, and Corporate Governance Some industries, such as the airline industry are characterized by high fixed costs, namely investments in equipment. The Sarbanes-Oxley Act requires public companies to disclose material changes in these fixed costs within four business days after they occur. 1-42  End of Week 9 McGraw-Hill/Irwin 1-43