CVP Analysis PDF

Cost-volume-profit relationships Dr. Ruth VanceLee Break-even … any ideas? Dr. Ruth VanceLee Break-even Break-even point (BEP) is the point at which cost or expenses and revenue are equal. There is no loss or gain, and one has...

Cost-volume-profit relationships Dr. Ruth VanceLee Break-even … any ideas? Dr. Ruth VanceLee Break-even Break-even point (BEP) is the point at which cost or expenses and revenue are equal. There is no loss or gain, and one has "broken even". A profit or a loss has not been made. Sales above breakeven result in a profit Sales below breakeven result in a loss Dr. Ruth VanceLee Break-even Analysis The study of the interrelationships between costs, volume and profit at various levels of activity. Break-even point is the level of sales where revenue = expenses and Net income is zero. Dr. Ruth VanceLee CVP Analysis We also are concerned with costs and profits for activity levels which produce profit (not just break-even) so more commonly we call Break-even Analysis Cost-volume-profit analysis (CVP) Dr. Ruth VanceLee CVP Analysis CVP Analysis asks – What will happen to the financial results if an organisation changes it level of activity? Benefit – With limited resources, knowledge of how costs fluctuate with changes in volume helps managers understand how to control costs Dr. Ruth VanceLee Uses of CVP Ideal for short-run decisions as we are analysing the relationship between costs, revenue, output levels and the resulting profit. e.g. Decisions – choice of sales mix pricing policies multi-shift working special order acceptance Dr. Ruth VanceLee To prepare CVP Analysis Step 1: Classify costs Fixed Costs = Variable Costs = Mixed Costs = Tell me Dr. Ruth VanceLee Step 2: Calculate contribution Contribution represents an amount available (after all variable costs are paid) to contribute towards fixed costs Contribution per unit is the amount that each unit sold adds to profit Contribution = Selling Price – Variable Costs Dr. Ruth VanceLee  Contribution example Aussie Travel Contribution Margin Income Statements Total Unit % Sales revenue €250,000 25 100% Variable expenses - 100,000 10 - 40% Contribution margin €150,000 15 =60% Fixed expenses - 170,000 Operating income (loss) € (20,000) Dr. Ruth VanceLee  Example 1– Contribution The following information relates to Product J: Selling price per unit €40 Variable costs per unit €24 Total fixed costs €200,000 Requirement: Calculate the contribution per unit. Chat Dr. Ruth VanceLee  Example 2– Contribution to Sales Ratio The following information relates to Product J: Selling price per unit €40 Variable costs per unit €24 Total fixed costs €200,000 Requirement: Calculate the contribution to sales (C/S) ratio Chat Dr. Ruth VanceLee Solution – Contribution to Sales Ratio Contribution = Selling Price – Variable Costs = €40 – €24 = €16 C/S Ratio = Contribution per unit x 100 Selling Price per unit = €16 / €40 x 100 = 40% Dr. Ruth VanceLee Step 3: Calculate Breakeven Formulae needed a) Break-even (in units) = Fixed Costs Contribution per unit b) Break-even (€ sales) = Fixed Costs x Sales Price/unit Contribution per unit Dr. Ruth VanceLee  Example 3 A company makes a single product with a sales price of €10 and a marginal (variable) cost of €6. Fixed costs are €60,000 p.a. Their target profit is €20,000 p.a. for this product. Using CVP formulae provide information to the company’s managers. 3 steps: 1. Identify FC & VC 2. Calculate contribution (Sales-VC) 3. Calculate breakeven (FC/contribution) Dr. Ruth VanceLee Other Formulae needed Contribution/Sales ratio = Contribution per unit x 100 Sales per unit Level of sales to result in target profit (units) = Fixed Cost + target profit Contribution per unit Dr. Ruth VanceLee Other Formulae needed Level of sales to result in target profit (€sale) = (Fixed Cost + Target Profit) x Sales price/unit Contribution per unit Dr. Ruth VanceLee Marginal Costing – Alternate method Total Sales {selling price * units sold} -Variable Costs {VC * units sold} Margin or Contribution -Fixed Costs Net income Dr. Ruth VanceLee Marginal Costing - Alternate method Sales – var.costs – fixed costs = net profit Net profit at breakeven is zero so Sales - var.costs – fixed costs = zero See Example 2 Dr. Ruth VanceLee Example 4 Port Williams Inc produced the following summary when they sold 20000 units Net Revenue €800,000 Expenses (inc €400,000 fixed) €880,000 Net Loss €(80,000) They plan on spending €200,000 more in advertising. 1. What is the contribution margin in total and per unit? 2. What is the total profit/loss if they advertise more? 3. At what sales volume will the store breakeven? 4. What sales volume will result in a profit of €40,000 Dr. Ruth VanceLee Assumptions of CVP analysis Selling price is constant throughout the entire product range. Costs are linear throughout the entire relevant range, and they can be accurately divided into variable and fixed elements Dr. Ruth VanceLee Assumptions of CVP analysis In multiproduct companies the sales mix is constant In manufacturing companies, inventories do not change. The number of units produced equals the number of units sold Dr. Ruth VanceLee Weaknesses of break-even analysis Three general problems Non-linear relationships Stepped fixed costs Multi-product businesses Dr. Ruth VanceLee  Homework: Q1 from Canvas (selling pack Firth Ltd has fixed costs of €12,000. The variable costs are €3 per unit. The revenue price) is €9 per unit. You are required to draft a schedule as follows filling in the columns for each stage up to 10,000 units. No. of Fixed Variable Total Reven Profit Loss units cost € cost € cost € ue € € € 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000 Dr. Ruth VanceLee Class 2 Dr. Ruth VanceLee Q8: Question pack on Canvas Try it! The good health drinks tent at a local horse-racing event sells all its drinks at €2.50 each. The variable cost of each drink is €1.00 and the fixed cost for the one day event is €2,700 1 If 4000 drinks are sold in the day a) the contribution b) the Net profit 2 How many drinks does it need to sell to break even? Dr. Ruth VanceLee Breakeven Graphs Graphs may be used for CVP analysis where: A simple overview is sufficient The audience have no accounting background – a detailed numerical approach is to be avoided There are three main graphs/charts: 1. (Traditional) Breakeven graph 2. Contribution breakeven graph 3. Profit volume (P/V) graph Dr. Ruth VanceLee Breakeven Graph Lines to be shown on the Graph:  Total Sales Revenue  Total Costs  Fixed Costs Dr. Ruth VanceLee CVP by graph 1. Draw Axes – Horizontal = sales volume Vertical = € costs + revenues 2. Draw cost lines Fixed costs – parallel to horizontal axis Total costs – start at fixed costs 3. Draw revenue line – from point of origin Dr. Ruth VanceLee  Break-even chart Total sales Revenue/Cost (£) revenue Break even point r o fit P Total cost Variable costs oss L F Fixed costs 0 Volume of activity (units of output) Dr. Ruth VanceLee Breakeven Graph The graph depicts: Approximate levels of profit/loss at different sales levels within a ‘relevant range’ Breakeven point where Revenue intersects Total Cost line Margin of Safety – area between budgeted sales volume and breakeven sales revenue Dr. Ruth VanceLee Example 5 – Graph Method A company makes a single product with a total capacity of 400,000 litres p.a. Cost and sales data are as follows: Selling Price €1 per litre Marginal Cost €0.50 per litre Fixed Costs €100,000 Draw Break-even chart at an expected production level of 300,000 litres. See Lucy page 343 Dr. Ruth VanceLee  Changes in Costs & Revenues It is possible to show the effect of changes in costs & revenues by drawing additional lines on the charts The changes are of two types: Fixed cost changes – increases or decreases in fixed costs do not change the slope of the line, but alter the point of intersection & the break-even point Variable cost and sales price changes – these changes alter the slope of the line thus affecting break- even point & the shape of the profit and loss wedges Dr. Ruth VanceLee Sensitivity Analysis “What if” analysis What if the sales price changes? What if costs change? What if the sales mix changes? Dr. Ruth VanceLee Margin of Safety The margin by which sales can fall before a loss is made or the excess of expected sales over breakeven sales Drop in sales that the company can absorb before incurring a loss Used to evaluate the risk of current operations as well as the risk of new plans Dr. Ruth VanceLee Margin of Safety MoS can be expressed in units, €’s or % Margin of Safety in Units = Expected sales in units – Breakeven sales in units Margin of Safety in € = Margin of safety in units x Sale price per unit Dr. Ruth VanceLee Margin of Safety Margin on safety as a percentage = Margin of safety in units ÷ Expected sales in units Margin of safety in dollars ÷ Expected sales in $ Margin of safety as a percentage is the same whether units or € are used Dr. Ruth VanceLee  Example 6 – Margin of Safety The following information relates to Product R2: Selling price per unit €35 Variable costs per unit €21 Total fixed costs €175,000 Budgeted sales volume 16,500 units Requirement: Calculate the margin of safety in units and as a percentage of budgeted sales Dr. Ruth VanceLee Solution 6 – Margin of Safety Contribution = Selling Price – Variable Costs = 35 – 21 = €14 Breakeven Point (Units) = Fixed costs / contribution per unit = 175,000 /14 = 12,500 units MOS (Units) = Budgeted units – Breakeven units = 16,500 – 12,500 = 4,000 units MOS (%) = (Budgeted units - Breakeven units) Budgeted units = (16,500 – 12,500) / 16,500 x 100 = 24.24% Dr. Ruth VanceLee  2019 Exam paper Q3 PWY plc. manufactures accounting journals. The following is a budgeted Income Statement for the business for June 2018: Sales revenue 9,600 Direct material 4,000 Direct labour 960 Production overhead 3,600 Selling overhead 560 Profit 480 The following information is also supplied: The monthly budgeted production and sales is 4,000 units. A breakdown between fixed and variable costs applies: Variable Fixed Direct materials 100% n/a Labour € 400 560 Production overhead € 1,440 2,160 Selling overhead 100% n/a  2019 Exam paper Q3 continued Required: (a) Calculate the following: (i) Contribution for the year; (ii) Contribution per unit; (iii) Contribution / sales ratio; (iv) Breakeven sales volume; (v) Margin of safety %; (vi) Sales volume required to achieve a profit of€1,440. (6*4 marks each) (b) Prepare a clearly labelled breakeven chart, showing the breakeven point, margin of safety and expected profit. (6 Marks) Total 30 marks Dr. Ruth VanceLee