Chapter 7: Cost-Volume-Profit (Part
1 of 3)
Sections 1 and 2
Feb 4, 2013
Professor: Khim Kelly
Office: HH386B
Office Hours: Mon/Wed 11:30am – 12:30pm and Appointment
Email: kokelly@uwaterloo.ca
TA: Kun Huo
Email: khuo@uwaterloo.ca
4 Feb 2013 Overview
• Last lecture
– Completed Chapter 6 (Cost Behavior)
• Today’s lecture …
– Basics of Chapter 7
– CM Ratio
– Break even Analysis
2
Cost-Volume-Profit
• Uses …
–
–
–
–
Breakeven analysis
Scenario analysis (i.e. change in inputs)
Cost structure planning and leverage
Indifference calculations
• CVP considers how income is affected by:
–
–
–
–
–
Prices of products (i.e. sales price)
Variable costs per unit
Total fixed cost
Volume or level of activity (‘X’)
Mix of products sold
Contribution Margin
• CM is used to cover fixed costs, THEN anything left
is profit
• Profit = Sales – Variable Costs – Fixed Costs
CM
Contribution Margin
•
•
•
•
Sales price per unit: $100
Variable cost per unit: $50
Fixed costs: $500,000
What would the operating income (loss) be if:
– 0 units produced?
Operating loss = CM – FC = Sales – VC – FC =
$0 – $0 - $500,000 = ($500,000)
– 1 unit produced?
Operating loss = CM – FC = Sales – VC – FC =
$100 – $50 - $500,000 = ($499,950)
– 10,000 units produced?
Operating loss = ????
Break-even Point
• Break-even point is …
– The level of sales at which profit = 0
– Also known as the point where total sales = total
expenses or where total contribution margin = fixed
expenses
Break-even point:
Profit = Sales – Variable Costs – Fixed Costs = $0
CM – Fixed Cost = $0
Total Expenses …
$
Total Expenses
Variable Expenses
Fixed Expenses
Activity
CVP Relationships in Graphical Form
Total Sales Revenue
$
Total Expenses
As long as Contribution Margin > 0
Activity
CVP Relationships in Graphical Form
Total Sales Revenue
$
Total Expenses
Activity
Contribution Margin Ratio
• CM ratio …
– Contribution margin (Sales less Variable Expenses) as a
percentage of total sales (say 40%)
– For every $1 of sales increase, CM will increase by $0.40
– The effect on operating income of any dollar change in total
sales can be computed by applying the CM ratio to the
dollar change
CM Ratio =
Total CM
Total Sales
=
Total CM per unit
Total Sales per unit
Change in op income = Change in sales x CM Ratio
It is Clicker Time!!
Feel Free to Work Together on Clicker Questions
Clicker Question #1
Q: Dillon’s (Khim’s son) garage band – Tone Death
– sold out 40 concerts in Khim’s basement, had
total revenue of $3000, variable expenses of
$2400, and total fixed expenses of $450. What is
the band’s contribution margin ratio?
A.
B.
C.
D.
E.
25%
$600
20%
$150
Ozzy Osbourne
Clicker Question #2
Q: Dillon’s garage band – Tone Death – sold out 40
concerts, had total revenue of $3,000, variable
expenses of $2,400, and total fixed expenses of
$450. Estimate the change in the band’s income if
total sales increased by $1,500 to a total of $4,500
(i.e., Khim forced all her AFM102 students to buy
tickets)?
A.
B.
C.
D.
E.
($150)
$300
($5,012.62)
$150
$450
Clicker Question #3
Q: Acoustic is selling 400 speakers per month @
$250 per speaker for total monthly sales of
$100,000. Current variable costs are $60,000
and current fixed costs are $35,000. Financially
speaking, should they increase sales by $30,000
by increasing fixed costs (advertising) by
$10,000?
A. Yes
B. No
Example: Application of CVP
Solution 1:
CM Ratio [(100k – 60k)/100k]
40%
Expected CM with new advertising $52K
(130K*40%)
Current CM (100K*40%)
$40K
Incremental CM
$12K
Change in Fixed Costs
($10K)
Change in Operating Income
$2K
Example: Application of CVP
Solution 2 (incremental approach):
Incremental CM (30K*40%)
Change in Fixed Costs
Change in Operating Income
•
•
$12K
($10K)
$2K
Incremental analysis focuses only on the items
that will change as a result of a decision.
In general, if a change result in Increase in CM >
Increase in fixed costs [or Decrease in CM <
Decrease in fixed costs], then the change should
be made
Change VC + Target Profit (P7-27)
You manufacture skateboards that sell for $37.50. Rely on
direct labour workers and variable costs are $22.50 per board.
In the last year you sold 40,000 boards:
Q. Increase of $3 in labour per board expected. How many
boards do you need to make to earn the same Op. Income?
Income Statement
Sales
VC
CM
FC
Op. Income
Before:
1,500,000 Old Unit CM = $37.50 – $22.50 = $15
$15*40,000 - $480,000 = $120,000
900,000
$600,000 Now (Increase in VC):
480,000
$120,000
17
Change VC + Target Profit (P7-27)
Alternatively:
FC is not a differential cost (see pg. 47). Therefore, the
simplest way is to make the CM of both options equal.
Income Statement
Sales
VC
CM
FC
Op. Income
1,500,000
900,000
$600,000
480,000
$120,000
Before:
Old CM = $15*40,000
Now (Increase in VC):
New CM = $12*X
CM equivalence:
18
Change VC + CM Ratio (P7-27)
You manufacture skateboards that sell for $37.50. Rely on direct
labour workers and variable costs are $22.50 per board. In the last
year you sold 40,000 boards:
Q. Increase of $3 in labour per board expected. What is the sales
price for the same CM Ratio?
Income Statement
Sales
VC
CM
FC
Op. Inc.
Before:
CM Ratio = $600,000/$1,500,000 = 40%
1,500,000
900,000 Now (Increase in VC):
$600,000
480,000
$120,000
19
Shift to FC from VC (P7-27)
You manufacture skateboards that sell for $37.50. Rely on direct
labour workers and variable costs are $22.50 per board. In the last
year you sold 40,000 boards:
Q. Should you automate your manufacturing? This results in VC to
decrease 40% and FC to increase 90%. How many units (X) do we
need to earn the same Op. Income?
Income Statement
Income Statement
Sales
VC
CM
FC
Op. Inc.
1,500,000
900,000
$600,000
480,000
$120,000
Sales
VC
CM
FC
Op. Inc.
$37.50X
($22.5*0.6)X
$24.00X
$480,000 * 1.9
$120,000
20
Shift to FC from VC (P7-27)
Op. Inc = CM – FC
Income Statement
Sales
VC
CM
FC
Op. Inc.
1,500,000
900,000
$600,000
480,000
$120,000
Income Statement
Sales
VC
CM
FC
Op. Inc.
$37.50X
$13.50X
$24.00X
$912,000
$120,000
21
Important points
• Use the formula flexibly
– Income = Sales – VC – FC
– Income = Units sold * price – units sold * VC per unit –
FC
– Income = Units sold * (price – VC per unit) – FC
• We test you by changing any of the variables but
the concept remains the same!
• Make sure you identify the variable of interest
first
• Buy Dillion’s concert tickets, circa 2025, spaces
are limited!
Summary
• Today’s lecture …
– Basics of CVP
– Contribution Margin ratio
– Break even analysis
• Next lecture …
– More break even analysis
– Margin of safety analysis
– Target operating profit analysis