Cost-Volume-Profit Analysis

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Cost-Volume-Profit Analysis
Chapter 3
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2009 Foster Business School
Cost Accounting
L.DuCharme
Outline
• CVP assumptions & terminology
• BEP solution
– Target operating income
– Target net income
• Margin of Safety
• Operating Leverage
• CM vs. GM
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2009 Foster Business School
Cost Accounting
L.DuCharme
Assumptions
Four assumptions
underlying cost-volume-profit
(CVP) analysis are presented
in the text.
We will assume that they hold here.
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2009 Foster Business School
Cost Accounting
L.DuCharme
Cost-Volume-Profit Terminology
Operating income
= Total revenues from operations
– Cost of goods sold and operating costs
(excluding income taxes)
Net income = Operating income – Income taxes
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2009 Foster Business School
Cost Accounting
L.DuCharme
(CVP) Analysis Example
Assume that the Pants Shop can purchase pants
for $32 from a local factory; other variable costs
amount to $10 per unit.
The local factory allows the Pants Shop to
return all unsold pants and receive a full $32
refund per pair of pants within one year.
The average selling price per pair of pants is $70
and total fixed costs amount to $84,000.
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2009 Foster Business School
Cost Accounting
L.DuCharme
(CVP) Analysis Example
How much revenue will the business receive if
2,500 units are sold?
2,500 × $70 = $175,000
How much variable costs will the business incur?
2,500 × $42 = $105,000
$175,000 – 105,000 – 84,000 = ($14,000)
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2009 Foster Business School
Cost Accounting
L.DuCharme
(CVP) Analysis Example
What is the contribution margin per unit?
$70 – $42 = $28 contribution margin per unit
What is the total contribution margin when
2,500 pairs of pants are sold?
2,500 × $28 = $70,000
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2009 Foster Business School
Cost Accounting
L.DuCharme
(CVP) Analysis Example
Contribution margin percentage (contribution
margin ratio) is the contribution margin per
unit divided by the selling price.
What is the contribution margin percentage?
$28 ÷ $70 = 40%
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2009 Foster Business School
Cost Accounting
L.DuCharme
(CVP) Analysis Example
If the business sells 3,000 pairs of pants,
revenues will be $210,000 and contribution
margin would equal 40% × $210,000 = $84,000.
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2009 Foster Business School
Cost Accounting
L.DuCharme
BEPs
Determine the breakeven point
and output level needed to achieve
a target operating income using:
(1) the equation,
(2) contribution margin, and
(3) graph methods.
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2009 Foster Business School
Cost Accounting
L.DuCharme
Breakeven Point
–
Sales
Variable
expenses
=
Fixed
expenses
Total revenues = Total costs
Rev – VC – FC = 0
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2009 Foster Business School
Cost Accounting
L.DuCharme
Abbreviations
SP = Selling price
VCU = Variable cost per unit
CMU = Contribution margin per unit
CM% = Contribution margin percentage
FC = Fixed costs
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2009 Foster Business School
Cost Accounting
L.DuCharme
Abbreviations
Q = Quantity of output units sold
(and manufactured)
OI = Operating income
TOI = Target operating income
TNI = Target net income (after tax)
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Cost Accounting
L.DuCharme
Equation Method
(Selling price × Quantity sold) – (Variable unit cost
× Quantity sold) – Fixed costs = Operating income
Let Q = number of units to be sold to break even
$70Q – $42Q – $84,000 = 0
$28Q = $84,000
Q = $84,000 ÷ $28 = 3,000 units
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Cost Accounting
L.DuCharme
Contribution Margin Method
$84,000 ÷ $28 = 3,000 units
$84,000 ÷ 40% = $210,000
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Cost Accounting
L.DuCharme
$(000)
Graph Method
Breakeven
378
336
294
252
210
168
126
84
42
0
Fixed costs
0
1000
2000
3000
4000
5000
Units
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Cost Accounting
L.DuCharme
Target Operating Income
(Fixed costs + Target operating income)
divided either by Contribution Margin
percentage or Contribution Margin per unit
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Cost Accounting
L.DuCharme
Target Operating Income
Assume that management wants to have an
operating income of $14,000.
How many pairs of pants must be sold?
($84,000 + $14,000) ÷ $28 = 3,500
What dollar sales are needed to achieve this income?
($84,000 + $14,000) ÷ 40% = $245,000
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Income Taxes
Understand how income
taxes affect CVP analysis.
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Cost Accounting
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Target Net Income
and Income Taxes Example
Management would like to earn
an after tax income of $35,711.
The tax rate is 30%.
What is the target operating income?
Target operating income
= Target net income ÷ (1 – tax rate)
TOI = $35,711 ÷ (1 – 0.30) = $51,016
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2009 Foster Business School
Cost Accounting
L.DuCharme
Target Net Income
and Income Taxes Example
How many units must be sold?
Revenues – Variable costs – Fixed costs
= Target net income ÷ (1 – tax rate)
$70Q – $42Q – $84,000 = $35,711 ÷ 0.70
$28Q = $51,016 + $84,000
Q = $135,016 ÷ $28 = 4,822 pairs of pants
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2009 Foster Business School
Cost Accounting
L.DuCharme
Target Net Income
and Income Taxes Example
Proof:
Revenues: 4,822 × $70
Variable costs: 4,822 × $42
Contribution margin
Fixed costs
Operating income
Income taxes: $51,016 × 30%
Net income
$337,540
202,524
$135,016
84,000
51,016
15,305
$ 35,711
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Cost Accounting
L.DuCharme
Margin of Safety (MoS)
Margin of Safety = Revenues* – BEP
(*Revenues are either budgeted or actual.)
MoS can either be expressed in # of units or $.
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Cost Accounting
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MoS--question
Brie Soda has sales of $200,000; a CM of
20%; and a margin of safety of $80,000.
What is Brie’s fixed cost?
A. $16,000
B. $24,000
C. $80,000
D. $96,000
E. None of the above
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Cost Accounting
L.DuCharme
Operating Leverage
Operating leverage describes the effects that
fixed costs have on changes in operating
income as changes occur in units sold.
Organizations with a high proportion of fixed
costs have high operating leverage.
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Cost Accounting
L.DuCharme
Operating Leverage Example
Degree of operating leverage
= Contribution margin ÷ Operating income
What is the degree of operating leverage
of the Pants Shop at the 3,500 sales level
under two different arrangements?
Existing arrangement:
3,500 × $28 = $98,000 contribution margin
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2009 Foster Business School
Cost Accounting
L.DuCharme
Operating Leverage Example
$98,000 contribution margin – $84,000 fixed costs
= $14,000 operating income
$98,000 ÷ $14,000 = 7.0
New arrangement:
Assume Unit Variable Costs = $35 and Fixed Cost = $114,000
3,500 × $35 = $122,500 contribution margin
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2009 Foster Business School
Cost Accounting
L.DuCharme
Operating Leverage Example
$122,500 contribution margin
– $114,000 fixed costs = $8,500
$122,500 ÷ $8,500 = 14.4
The degree of operating leverage at a given level
of sales helps managers calculate the effect of
fluctuations in sales on operating income.
E.g., above: a 10% increase in sales will yield a 144% increase in op. income!
What is operating leverage if fixed costs = 0?
As sales increase, what happens to op. leverage?
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Cost Accounting
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Contribution Margin versus
Gross Margin
Contribution income statement emphasizes
contribution margin.
Financial accounting income statement
emphasizes gross margin.
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2009 Foster Business School
Cost Accounting
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GM versus CM
• The difference between GM and CM all is
in how you account for:
– Fixed mfg. costs (in CoGS, NOT in VC)
– Variable non-mfg. costs (in VC, NOT in CoGS)
GM = Rev. – CoGS
CM = Rev. – VC
“Margins” are usually referred to in finance. What margins are they usually referring to?
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2009 Foster Business School
Cost Accounting
L.DuCharme
End of Chapter 3
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2009 Foster Business School
Cost Accounting
L.DuCharme
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