Part Five Cost­Volume­Profit Analysis
COST­VOLUME­PROFIT ANALYSIS Ø Study of the effects of changes of costs and volume on a company’s profits Ø A critical factor in management decisions Ø Important in profit planning
COST­VOLUME­PROFIT ANALYSIS Ø Considers the interrelationships among the five components of CVP analysis:
ASSUMPTIONS UNDERLYING CVP ANALYSIS(Assumptions) Ø Behavior of both costs and revenues is linear throughout the relevant range of the activity index Ø All costs can be classified as either variable or fixed with reasonable accuracy Ø Changes in activity are the only factors that affect costs Ø All units produced are sold Ø When more than one type of product is sold, the sales mix will remain constant
CVP INCOME STATEMENT Ø A statement for internal use Ø Classifies costs and expenses as fixed or variable Ø Reports contribution margin in the body of the statement. § Contribution margin – amount of revenue remaining after deducting variable costs Ø Reports the same net income as a traditional income statement
CVP INCOME STATEMENT Contribution Margin Per Unit Ø Contribution margin is available to cover fixed costs and to contribute to income Ø Formula for contribution margin per unit: Unit Selling Price – Unit Variable Costs = Contribution Margin per Unit Ø Example: Computation for Vargo Video Unit Selling Price $500 – Unit Variable Costs $300 = Contribution Margin per Unit $200
CVP INCOME STATEMENT Contribution Margin Ratio Ø Shows the percentage of each sales dollar available to apply toward fixed costs and profits Contribution Margin per Unit ÷ Unit Selling Price = Contribution Margin Ratio Ø Example: Computation for Vargo Video Contribution Margin per Unit S200
÷ Unit Selling Price $500 = Contribution Margin Ratio 40% BREAK­EVEN ANALYSIS Ø Process of finding the break­even point Ø Break­even point § Level of activity at which total revenues equal total costs (both fixed and variable) § Can be computed or derived • from a mathematical equation • by using contribution margin • from a cost­volume­profit (CVP) graph § Expressed either in sales units or in sales dollars
BREAK­EVEN ANALYSIS Mathematical Equation Example using the Vargo Video data: Sales $500 Q Variable Costs Fixed Costs Net Income $300 Q $200,000 $0 = + + $200 Q = $200,000 Q =
1000 units Where: Q = sales volume; $500 = selling price; $300 = variable cost per unit; $200,000 total fixed costs ØTo find sales dollars required to break­even: 1000 units X $500 = $500,000 (break­even sales dollars) • Breakeven point Ø Volume of sales needed to earn no profit or no loss Ø Revenues = total costs Fixed cost + target profit = number of units Contribution margin per unit Fixed cost + target profit = dollars of sales
Contribution margin percentage • The breakeven formulas allow us to play “what if” games – What happens if • Sales price is increased (or decreased) • Variable costs are replaced by fixed costs • Volume increases • Additional amounts spent on advertising will increase sales volume • Etc.
Margin of safety – The excess of current sales volume over the breakeven point – In units • Current unit sales – breakeven unit sales – In percentage • (Current sales – breakeven sales) / current sales – The sales figures may be in dollars or units
BREAK­EVEN ANALYSIS Margin of Safety Ø Difference between actual or expected sales and sales at the break­even point Ø May be expressed in dollars or as a ratio Ø Example ­ To determine the margin of safety in dollars for Vargo Video assuming that actual (expected) sales are $750,000: Actual (Expected) Sales S750,000
– Break­even Sales $500,000 = Margin of Safety in Dollars $250,000 BREAK­EVEN ANALYSIS Margin of Safety Ratio Ø Computed by dividing the margin of safety in dollars by the actual or expected sales (using Vargo Video data) Margin of Safety in Dollars $250,000
÷ Actual (Expected) Sales $750,000 = Margin of Safety Ratio 33% Ø Results indicate that Vargo Video’s sales could fall by 33 percent before it would be operating at a loss. Ø The higher the dollars or the percentage, the greater the margin of safety. BREAK­EVEN ANALYSIS Contribution Margin Technique Ø At the break­even point, contribution margin must equal total fixed costs (CM = total revenues – variable costs) Ø The break­even point can be computed using either contribution margin per unit or contribution margin ratio § When the break even point in units is desired, contribution margin per unit is used in the following formula Fixed Costs ÷ Contribution Margin per Unit = Break­even Point in Units § When the break even point in dollars is desired, contribution margin ratio is used in the following formula Fixed Costs ÷ Contribution Margin Ratio
= Break­even Point in Dollars BREAK­EVEN ANALYSIS Contribution Margin Technique Example using Vargo Video data: Fixed Costs ÷ Contribution Margin per Unit = Break­even Point in Units $200,000 $200 1,000 units Fixed Costs Contribution Margin per Unit Break­even Point in Dollars $200,000 ÷ 40%
= $500,000 BREAK­EVEN ANALYSIS Graphic Presentation Ø A cost­volume­profit (CVP) graph shows costs, volume, and profits Ø Used to visually find the break­even point Ø To construct a CVP graph, § Plot the total revenue line starting at the zero activity level § Plot the total fixed cost by a horizontal line § Plot the total cost line. (Starts at the fixed cost line at zero activity) § Determine the break­even point from the intersection of the total cost line and the total revenue line
BREAK­EVEN ANALYSIS CVP Graph for Vargo Video
Cost­Volume­Profit Graph 450,000 350,000 Sales in Dollars Total sales Break
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Break­even point $(80,000) $(100,000) 1 2 3 4 5 Units sold (00s) 6 7 8 BREAK­EVEN ANALYSIS Target Net Income Ø Level of sales necessary to achieve a specified income Ø Can be determined from each of the approaches used to determine break­even sales/units Ø May be expressed either in sales dollars or sales units
Sensitivity analysis • Change in Sales Price • Change in Variable Costs • Change in Fixed Costs • Change in Volume
Operating leverage – Measures the relative mix of fixed and variable costs – Contribution margin / operating income – Can determine the change in operating income that will result from a change in sales by multiplying the % change in sales by the operating leverage – High operating leverage implies high risk, high reward
• Breakeven calculations in a multi­product environment – Assume the mix of products sold remains constant – Determine the contribution margin for a “basket” of goods (the normal sales mix) – Calculate the breakeven point as the number of “baskets” needed to break even
Breakeven calculations in a multi­ product environment Product Laptops Printers Scanners Normal Contribution Total sales mix per unit contribution 6 $ 70 $ 420 2 30 60 1 20 20 $ 500 If fixed costs are $800,000, the breakeven point is $800,000 / 500 = 1,600 "baskets" 9,600 laptops 3,200 printers 1,600 scanners
Computing Multiproduct Break­Even Point • Unit contribution margin is replaced with contribution margin for a composite unit. • A composite unit is composed of specific numbers of each product in proportion to the product sales mix. • Sales mix is the ratio of the volumes of the various products.
Computing Multiproduct Break­Even Point
The resulting break­even formula for composite unit sales is: Break­even point = in composite units Fixed costs Contribution margin per composite unit Computing Multiproduct Break­Even Point A company sells windows and doors. They sell 4 windows for every door.
Selling Price Variable Cost Unit Contribution Sales Mix Ratio Windows Doors $200 $500 125 350 $ 75 $ 150 4 1 Computing Multiproduct Break­Even Point Step 1: Compute contribution margin per composite unit. Selling Price Variable Cost Unit Contribution Sales Mix Ratio Composite C/M
Windows Doors $200 $500 125 350 $ 75 $ 150 Computing Multiproduct Break­Even Point
Step 2: Compute break­even point in composite units. Fixed costs Break­even point = in composite units Contribution margin per composite unit Computing Multiproduct Break­Even Point Step 2: Compute break­even point in composite units. Break­even point in composite units = Fixed costs Contribution margin per composite unit $900,000 Break­even point in composite units = Break­even point in composite units = 2,000 composite units
$450 per composite unit Computing Multiproduct Break­Even Point
Step 3: Determine the number of windows and doors that must be sold to break even. Sales Composite Product Mix Units Units Window 4 × 2,000 = 8,000 Door 1 × 2,000 = 2,000 Multiproduct Break­Even Income Statement
Step 4: Verify the results. Windows Selling Price $200 Variable Cost 125.00 Unit Contribution $ 75.00 Sales Volume × 8,000 Total Contribution $ 600,000 Fixed Costs Income Doors $500 350.00 $ 150.00 × 2,000 $ 300,000 Combined $ 900,000 900,000 $ 0 Thanks for Your Attention