Chapter 15 - CVP Analysis PDF

Chapter 15 – CVP Analysis Chapter Objectives – Be able to: 1. explain the difference between contribution (variable) income statements and functional (GAAP) income statements 2. discuss and calculate Contribution Margin (in total and per unit) 3. identify the assumptions needed to apply CVP...

Chapter 15 – CVP Analysis Chapter Objectives – Be able to: 1. explain the difference between contribution (variable) income statements and functional (GAAP) income statements 2. discuss and calculate Contribution Margin (in total and per unit) 3. identify the assumptions needed to apply CVP analysis 4. use the CVP model to calculate Break Even point and other information including Margin of Safety 5. define Operating Leverage and apply Operating Leverage Ratio to assess opportunities for profit and the risk of loss 1  Income Statement Formats Contribution Functional (GAAP) Income Statement Income Statement  Costs are classified according  Costs are classified according to behavior to function  Variable  Manufacturing  Fixed  Selling and administrative  Contribution margin  Gross Margin  Total revenues less total  Total revenues less cost of variable costs goods sold  Represents the amount  Represents the amount that goes toward covering that goes toward covering fixed costs and providing other expenses and a profit providing a profit 2  Example Chillin’ Time produces and sells one product, ice cream bars, for $1.50 each. To ensure top quality, no inventories are maintained. Estimated costs are: Variable Costs Per Ice Cream Bar Fixed Costs Per Month Manufacturing costs: Manufacturing overhead $1,200 Direct materials $0.43 Selling and administrative 580 Direct labor 0.32 Total $1,780 Manufacturing overhead 0.20 $0.95 Selling and administrative 0.15 Total $1.10 3  Functional Income Statement Example CHILLIN’ TIME Functional Income Statement For a Monthly Volume of 6,950 Ice Cream Bars Sales (6,950 x $1.50) $10,425. Less cost of goods sold: Direct materials (6,950 x $0.43) $2,988 Direct labor (6,950 x $0.32) 2,224 Variable manufacturing overhead (6,950 x $0.20) 1,390 Fixed manufacturing overhead 1,200 (7,802) Gross margin 2,623. Less other expenses: Variable selling and administrative (6,950 x $0.15) 1,043 Fixed selling and administrative 580 (1,623) Profit $ 1,000. 4  Contribution (Variable) Income Statement Example CHILLIN’ TIME Contribution Income Statement For a Monthly Volume of 6,950 Ice Cream Bars $10,425. Sales (6,950 x $1.50) Less variable costs: Direct materials (6,950 x $0.43) $2,988 Direct labor (6,950 x $0.32) 2,224 Manufacturing overhead (6,950 x $0.20) 1,390 Selling and administrative (6,950 x $0.15) 1,043 (7,645) Contribution margin 2,780. Less fixed costs: Manufacturing 1,200 Selling and administrative 580 (1,780) Profit $ 1,000. 5  Contribution Margin Calculations Chillin’ Time’s contribution income appears below: Total Per Unit Sales (6,950 units) $ 10,425 $ 1.50 Variable costs (7,645) (1.10) Contribution margin 2,780 Fixed costs (1,780) Profit $ 1,000 Contribution margin $1.50 – $1.10 = $0.40 per unit Contribution margin [$1.50 – $1.10] / $1.50 = 0.2667 ratio 6  Cost-Volume-Profit Analysis CVP A technique to examine the relationships among total volume of an independent variable, total costs, total revenues, and profits for a time period  Useful in the early stages of planning  Provides an easily understood framework for discussing planning issues and organizing relevant data 7  CVP Model Applications Provides answers to questions such as…  How many cappuccinos must Starbucks sell to earn total profit of $50,000?  At what sales volume will McDonald’s total revenues and total costs be equal (i.e., Break Even point)?  What profit will Office Max earn at sales volume of $200 million?  What will happen to Disney’s profit if ticket selling prices are increased by 10% and fixed costs increase by 8%?  How much money must be raised from alumni at Princeton to provide 50 full scholarships? 8  CVP Assumptions 1. All costs are classified as fixed or variable 2. The total cost function is linear within the relevant range 3. The total revenue function is linear within the relevant range 4. The analysis is for a single product, or the sales mix of multiple products is constant 9  Variable and Fixed Components Variable manufacturing costs All variable costs associated with converting raw Variable materials into finished goods Costs Variable selling and administrative costs All variable costs not directly associated with converting raw materials into finished goods Fixed manufacturing overhead All fixed costs associated with converting raw Fixed materials into finished goods Costs Fixed selling and administrative costs All fixed costs not directly associated with converting raw materials into finished goods 10  Calculating Target Profit Example Chillin’ Time produces and sells one product, ice cream bars, for $1.50 each. To ensure top quality, no inventories are maintained. Estimated costs are: Variable Costs Per Ice Cream Bar Fixed Costs Per Month Manufacturing costs: Manufacturing overhead $1,200 Direct materials $0.43 Selling and administrative 580 Direct labor 0.32 Total $1,780 Manufacturing overhead 0.20 $0.95 Units Selling andsold to earn administrative $1,000 0.15 Chillin’ Time must sell Total $1.10 6,950 ice cream bars $1,000 = $1.50X - $1.10X - $1,780 each month to result X = 6,950 ice cream bars in $1,000 profit 11  Break-Even Point in Units Occurs when total revenues equal total costs Fixed costs = Selling price per unit – Variable costs per unit Fixed costs = Unit Contribution Margin Margin of Safety is the amount of units by which actual or planned units exceed the Break-Even point 12  Break-Even Point Example Chillin’ Time sells ice cream bars with a $1.10 unit variable cost for $1.50 each. How many bars must it sell to break even? Fixed costs = Unit contribution margin Chillin’ Time’s $1,780 Break-Even Unit = = 4,450 units Sales Volume $.40 When Chillin’ Time sells 4,450 ice cream bars per month, it will break even. So the margin of safety is 6,950 – 4,450 = 2,500 units. 13  Target Profit Example If Chillin’ Time wants to earn a monthly profit of $800, how many ice cream bars must it sell? Target unit = Fixed costs + Desired profit sales volume Unit contribution margin Chillin’ Time’s $1,780 + $800 Target Unit = = 6,450 units Sales Volume $.40 When Chillin’ Time sells 6,450 ice cream bars per month, it will generate profit of $800 14  Net Income Change Examples Total Per Unit Ratio to Sales Sales (6,950 units) $10,425. $ 1.50 1.000 Variable costs (7,645) (1.10) (0.733) Contribution margin 2,780. $ 0.40 0.2667 Fixed costs (1,780) Profit $ 1,000. If sales increase by 100 ice cream bars per month, by how much will net income increase? 100 x $0.40 = $40 If sales increase by $1,050 per month, by how much will net income increase? $1,050 x 0.2667 = $280 15  Cost-Volume-Profit Graph Break-even point Total costs line 4,450 units $1,780 + $1.10 per unit Total Revenues and Total Costs Total revenue line $1.50 per unit r e a $12,000 - fi ta $10,000 - Pro $8,000 - d c osts $6,000 - Fixe 80 $1,7 $4,000 - a rea o ss Variable costs line $2,000 - L $1.10 per unit $0 - 0 2,000 4,000 6,000 8,000 Unit Sales 16  Multiple Product Break-Even Point Applicable when unit information a company sells more than one product. Unit Fixed costs Break Even = Contribution margin per unit point But what if you have many products that have different contribution margins? 17  Sales Mix Analysis  Sales mix – the relative portion of unit or dollar sales that are derived from each product  When sales mix is constant, the basic cost- volume-profit model can be used effectively  When sales mix is not constant, must determine average unit contribution margin or average contribution margin ratio for each alternative mix 18  Operating Leverage  What is operating leverage? A measure of the extent that an organization’s costs are fixed Degree of Contribution margin operating leverage = Income before taxes  Is operating leverage good or bad to have? It depends! 19  Operating Leverage Risk and Opportunity Sales Increase Sales Decrease High operating High opportunity High risk leverage for profit increases of loss Low operating Low opportunity Low risk leverage for profit increases of loss The higher the degree of operating leverage…  The greater the opportunity for profit with increases in sales, AND  The greater the risk of large losses when sales decrease 20  Measuring Expected Change in Profit Taco Express and Mia’s Cantina are competitors and reported the same sales revenue and before-tax profit during May: Taco Express Mia’s Cantina Sales $40,000 $40,000. Variable costs (22,000) (8,000) Contribution margin 18,000 32,000. Fixed costs (8,000) (22,000) Before-tax profit $10,000 $10,000. Taco Express Mia’s Cantina $18,000 $32,000 Degree of operating leverage = 1.8 = 3.2 $10,000 $10,000 If sales drop by 20% for both, which company suffers more? Decrease in profit 1.8 x 20% = 36% 3.2 x 20% = 64% Decline in Profit Decline in Profit Mia’s Cantina's higher operating leverage results in a larger profit decline 21