CVP Analysis PDF

Chapter 22 Cost-Volume-Profit 1 Analysis Dr Arafat Hossain Assistant Professor Southeast Business School Cost-Volume-Profit (CVP) 2 LEARNING OBJECTIVES LO...

Chapter 22 Cost-Volume-Profit 1 Analysis Dr Arafat Hossain Assistant Professor Southeast Business School Cost-Volume-Profit (CVP) 2 LEARNING OBJECTIVES LO5-0 Explain variable, fixed, and mixed costs and the relevant range. LO5–1 Explain how changes in activity affect contribution margin and net operating income. LO5–2 Prepare and interpret a cost-volume-profit (CVP) graph and a profit graph. LO5–3 Use the contribution margin ratio (CM ratio) to compute changes in contribution margin and net operating income resulting from changes in sales volume. LO5–4 Show the effects on net operating income of changes in variable costs, fixed costs, selling price, and volume LO5–5 Determine the break-even point. LO5–6 Determine the level of sales needed to achieve a desired target profit. LO5–7 Compute the margin of safety and explain its significance.  Cost-Volume-Profit (CVP) 3 Explain variable, fixed, and mixed costs and the relevant range: Variable Costs Variable costs are costs that vary in total directly and proportionately with changes in the activity level. If the level increases 10%, total variable costs will increase 10%. Examples of variable costs include direct materials and direct labor for a manufacturer. Fixed Costs Fixed costs are costs that remain the same in total regardless of changes in the activity level. Examples include property taxes, insurance, rent, supervisory salaries, and depreciation on buildings and equipment. Because total fixed costs remain constant as activity changes. Mixed Costs Mixed costs are costs that contain both a variable- and a fixed-cost element. Mixed costs, therefore, change in total but not proportionately with changes in the activity level. Utility costs such as for electricity are example of a mixed cost. Each month the electric bill includes a flat service fee plus a usage charge  Cost-Volume-Profit (CVP) 4 Prepare a CVP income statement to determine contribution margin: Cost-volume-profit (CVP) analysis helps managers make many important decisions such as what products and services to offer, what prices to charge, what marketing strategy to use, and what cost structure to maintain. Its primary purpose is to estimate how profits are affected by the following five factors: a) Selling prices b) Sales volume c) Unit variable costs d) Total fixed costs. e) Mix of products sold Cost-Volume-Profit (CVP) 5 The Basics of Cost-Volume-Profit (CVP) Analysis The contribution income statement emphasizes the behavior of costs and therefore is extremely helpful to managers in judging the impact on profits of changes in selling price, cost, or volume. Acoustic Concepts, Inc. Contribution Income Statement June, 30 Total Per Unit Sales (400 speakers) $100,000 $250 Variable expenses 60,000 150 Contribution margin 40,000 $100 Fixed expenses 35,000 Net operating income 5,000  Cost-Volume-Profit (CVP) 6 Contribution Margin Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. Notice the sequence here—contribution margin is used first to cover the fixed expenses, and the whatever remains goes toward profits. Contribution Income Statement Total Per Unit Sales (2 units) $500 $250 Variable expenses 300 150 Contribution margin 200 $100 Fixed expenses 35,000 Net Operating loss $(34,800)  Cost-Volume-Profit (CVP) 7 Contribution Margin (Contd.) If enough speakers can be sold to generate $35,000 in contribution margin, then all of the fixed expenses will be covered and the company will break even for the month—that is, it will show neither profit nor loss but just cover all of its costs. Contribution income statement Total Per Unit Sales (350 speakers) $87,500 $250 Variable expenses 52,500 150 Contribution margin 35,000 $100 Fixed expenses 35,000 Net operating income $0 Reach the break-even point  Cost-Volume-Profit (CVP) 8 Once the break-even point has been reached, net operating income will increase by the amount of the unit contribution margin for each additional unit sold. if 351 speakers are sold in a month, then the net operating income for the month will be $100. Contribution Income Statement Total Per Unit Sales (351 speakers) $87,750 $250 Variable expenses 52,650 150 Contribution 35,100 $100 Fixed expenses 35,000 Net operating income $100 Cost-Volume-Profit (CVP) 9 Cost-Volume-Profit (CVP) 10 Break-even Point The break-even point on the profit graph is the volume of sales at which profit is zero and is indicated by the dashed line on the graph. Note that the profit steadily increases to the right of the break-even point as the sales volume increases and that the loss becomes steadily worse to the left of the break-even point as the sales volume decreases. That graph is based on the following equation: Profit = (Unit CM X Unit sold) - Fixed expenses = ($100X300) - $35,000 = -$5,000 Cost-Volume-Profit (CVP) 11 Contribution Margin Ratio (CM Ratio) Now we show how the contribution margin ratio can be used in cost-volume-profit calculations. Total Per Unit Percent of Sales Sales (400 speakers) $100,000 $250 100% Variable expenses 60,000 150 60 Contribution margin 40,000 $100 40% Fixed expenses 35,000 Net operating income $5,000  Cost-Volume-Profit (CVP) 12 Contribution margin ratio (CM ratio) CM ratio = Contribution margin/sales = $40,000/$100,000 = 40% CM ratio can also be computed on a per unit basis as follows: CM ratio = Unit contribution margin/Unit selling price = $100/250 = 40% CM ratio of 40% means that for each dollar increase in sales, total contribution margin will increase by 40 cents ($1 sales X CM ratio of 40%). Net operating income will also increase by 40 cents, assuming that fixed costs are not affected by the increase in sales.  Cost-Volume-Profit (CVP) 13 Break-Even and Target Profit Analysis Break-Even Analysis The break-even point as the level of sales at which the firm’s profit is zero. To calculate the break-even point (in unit sales and dollar sales), managers can use either of two approaches, the equation method or the formula method. The Equation Method Profit = (Unit CM X Q) - Fixed expense Q = Unit sold $0 = ($100 X Q) - $35,000 $100 X Q = $0 + $35,000 Q = $35,000 / $100 = 350 units, break-even at sales volume of 350  Cost-Volume-Profit (CVP) 14 The Formula Method Break-even point in units: Units sales to break even = Fixed expenses/Unit CM = $35,000/$100 = 350 units (break-even units) Break-even in dollar sales: Dollar sales to break even = Fixed expenses/CM ratio = $35,000/0.40 = $87,500 (break-even dollars)  Cost-Volume-Profit (CVP) 15 Target Profit Analysis Target profit analysis is one of the key uses of CVP analysis. In target profit analysis, we estimate what sales volume is needed to achieve a specific target profit. The unit sales required to achieve a target profit of $40,000 per month, the company’s contribution margin per unit is $100 and its total fixed expenses are $35,000, the equation method could be applied as follows: The Equation Method Profit = (Unit CM X Q) - Fixed expense $40,000 = $100XQ - $35,000 $100 X Q = $40,000 + $35,000 Q = 750 units.  Cost-Volume-Profit (CVP) 16 The Formula Method: Units sales to attain the target profit = (Target profit + Fixed expenses)/Unit CM = ($40,000 + $35,000)/$100 = 750 units Target Profit Analysis in Terms of Dollar Sales: Target profit $40,000, contribution margin ratio 40%, fixed expenses $35,000. The equation method- Profit = (CM ratio X Sales) - Fixed expenses $40,000 = 0.40 X Sales - $35,000 Sales = $187,500. Dollar sales to attain a target profit = (Target profit + Fixed expenses)/CM Ratios ($40,000 + $35,000)/$0.40 $187,500.  Cost-Volume-Profit (CVP) 17 The Margin of Safety The margin of safety is the excess of budgeted or actual sales dollars over the break-even volume of sales dollars. It is the amount by which sales can drop before losses are incurred. The higher the margin of safety, the lower the risk of not breaking even and incurring a loss. The formula for the margin of safety is: Margin of safety in dollars = Total budgeted (or actual) sales - Break-even sales Sales (at the current volume of 400 speakers) (a)....... $100,000 Break-even sales (at 350 speakers)................... 87,500 Margin of safety in dollars (b)....................... $12,500. The margin of safety is $12,500. Its sales could fall $12,500 before it operates at a loss.  Cost-Volume-Profit (CVP) 18 The Margin of Safety (Contd.) The margin of safety can also be expressed in percentage form by dividing the margin of safety in dollars by total dollar sales: Margin of safety percentage = Margin of safety in dollars/Total budgeted (or actual) sales in dollars. Margin of safety percentage, (b)/(a).............. … 12.5% The company’s sales could fall by 12.5% before it operates at a loss. The higher the dollars or the percentage, the greater the margin of safety.  Cost-Volume-Profit (CVP) 19 The Margin of Safety (Contd.) In a single-product company like Acoustic Concepts, the margin of safety can also be expressed in terms of the number of units sold by dividing the margin of safety in dollars by the selling price per unit. In this case, the margin of safety is 50 speakers The margin of safety in units = (Margin of safety in dollars/selling price per unit) = ($12,500/$250 per speaker) = 50 speakers.  Cost-Volume-Profit (CVP) 20 Operating Leverage Operating leverage is a measure of how sensitive net operating income is to a given percentage change in dollar sales. Operating leverage acts as a multiplier. If operating leverage is high, a small percentage increase in sales can produce a much larger percentage increase in net operating income. The degree of operating leverage at a given level of sales is computed by the following formula: Degree of operating leverage = Contribution margin/Net operating income To illustrate, the degree of operating leverage for the two farms at $100,000 sales would be computed as follows: Bogside Farm: $40,000/$10,000= 4 Sterling Farm: $70,000/$10,000= 7 Because the degree of operating leverage for Bogside Farm is 4, the farm’s net operating income grows four times as fast as its sales.  Cost-Volume-Profit (CVP) 21 Operating Leverage (Contd.) If sales increase by 10%, then we can expect the net operating income of Bogside Farm to increase by four times this amount, or by 40%, and the net operating income of Sterling Farm to increase by seven times this amount, or by 70%. In general, this relation between the percentage change in sales and the percentage change in net operating income is given by the following formula: Percentage change in net operating income = (Degree of operating leverage X percentage change in sales) Bogside Farm: Percentage change in net operating income = 4 X 10% = 40% Sterling Farm: Percentage change in net operating income = 7 X 10% = 70%. Cost-Volume-Profit (CVP) 22 Home Exercises Do it! 3 CVP Income statement, Page: 973. Do it! 5 Break-Even, Margin of Safety, and Target Net Income, Page: 980. Do it! 22-6, Victoria Company, Page: 994. Exercise, E22-8, Spencer Kars, Page: 996.