Chapter 18 Cost volume profit analysis Copyright 2008

Chapter 18 Cost volume profit analysis Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -1

Cost volume profit (CVP) analysis A technique used to determine the effects of changes in an organisation’s sales volume on its costs, revenue and profit • Can be used in profit-seeking organisations and not-for-profit organisations • Not confined to profit-seeking enterprises • Commonly used in many not-for-profit situations • Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -2

The break-even point The volume of sales where the total revenues and expenses are equal, and the operation breaks even • At this level of sales, there is no profit or loss • Can be calculated for an entire organisation or individual projects • Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -3

Formulas Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -4

Terminology • Contribution margin (or variable costing) statement – A profit report where costs are reported by cost behaviour and a contribution margin is calculated – Fixed and variable costs are separated • Total contribution margin – The difference between the total sales revenue and the total variable costs – The amount available to cover fixed costs and then contribute to profits continued Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -5

Terminology • Unit contribution margin – The difference between the sales price per unit and the variable cost per unit • Contribution margin ratio – The unit contribution margin divided by the unit sales price – The proportion of each sales Rand available to cover fixed costs and earn a profit • Contribution margin percentage – The contribution margin ratio multiplied by 100 – The percentage of each sales Rand available to cover fixed costs and earn a profit Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -6

Projected revenues & costs at a theatre company (CTC) Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -7

Break-even number of tickets Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -8

Break-even point (in Rands) Unit Contribution margin = R 100 – R 35 = R 65 • Unit contribution margin as % of selling price = R 65/R 100 = 0. 65. Also called the unit contribution margin ratio. • Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -9

Cost-volume-profit graph for CTC Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -10

Profit volume (PV) graph Shows the total amount of profit or loss at different sales volumes • The graph intercepts the vertical axis at the amount equal to the fixed costs • The break-even point is the point at which the line crosses the horizontal axis • Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -11

Profit volume graph, CTC production of Calypso Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -12

Target net profit A desired profit level determined by management • Can be used within the break-even formula • Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -13

Target net profit • Assume that the target profit for theatre company is R 70 000 (we will use R 70 005 to avoid rounding differences) Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -14

Using CVP analysis for management decision making • Common applications include – – Safety margin Changes in fixed expenses Changes in the unit contribution margin Multiple changes in key variables Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -15

Safety margin Difference between the budgeted sales revenue and the break-even sales revenue • Gives a feel for how close projected operations are to the break-even point • Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -16

Changes in fixed costs • When estimates of fixed costs are revised, the break-even point will change – Percentage change in fixed expenses will lead to a similar increase in the break-even point (in units or Rands) • Different fixed costs may apply to different levels of sales/production volume – More than one break-even point Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -17

Changes in the unit contribution margin • Change in unit variable expenses – Changes the unit contribution margin – A new break-even point – An increase in unit variable expenses will increase the break-even point • Change in sales price – Changes the unit contribution margin – A new break-even point – An increase in unit price will lower the break-even point continued Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -18

Change in variable cost per ticket Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -19

Change in selling price & fixed costs Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -20

Cost volume profit graph with step-fixed costs, CTC production of Calypso Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -21

Multiple changes in key variables • May involve – – • Increasing unit prices Increasing selling prices Undertaking a new advertising campaign Leasing a new office An incremental approach to analysis – Focuses on the differences in the total contribution margin, fixed expenses and profits under the two alternatives Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -22

CVP analysis with multiple products • Sales mix – The relative proportions of each type of product sold by the organisation • Weighted average unit contribution margin – The average of the products’ unit contribution margins, weighted by the sales mix Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -23

CVP Analysis with multiple products • Weighted average unit contribution margin § • = (R 90 x 75%) + (R 50 x 25%) = R 80 Break-even Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -24

Profit volume graph with multiple products, CTC production of Calypso Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -25

Including income taxes in CVP analysis Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -26

Assumptions underlying CVP analysis The behaviour of total revenue is linear • The behaviour of total costs is linear over a relevant range • – Costs can be categorised as fixed, variable or semivariable – Labour productivity, production technology and market conditions do not change – There are no capacity changes during the period under consideration continued Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -27

Assumptions underlying CVP analysis For both variable and fixed costs, sales volume is the only cost driver • The sales mix remains constant over the relevant range • In manufacturing firms, the levels of inventory at the beginning and end of the period are the same • – Thus, the number of units produced and sold during a period are equal Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -28

CVP analysis and long-term decisions CVP analysis is usually regarded as a short-term or tactical decision tool • Classification of costs as variable or fixed is usually based on cost behaviour over the short term • The financial impact of long-term decisions is best analysed using capital budgeting techniques • – Takes into account the time value of money Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -29

Treating CVP analysis with caution CVP analysis is merely a simplified model • The usefulness of CVP analysis may be greater in less complex smaller firms, or stand-alone projects • For larger firms, CVP analysis can be valuable as a decision tool for the planning stages of new projects and ventures • Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -30

An activity-based approach to CVP analysis • ABC categorises activities as facility, product, batch or unit costs – Facility, product and batch activities are non-volume activity costs Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -31

Limiting assumptions of CVP analysis using activity-based costs Total batch level costs are dependent on the batch size and the break-even/target production level • Management may change the batch size at certain production volume levels and this will change the break-even volume • More complex models are needed where there are multiple products • Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -32

Including customer-related costs in CVP analysis • Some ABC systems include customer-related costs – – Order level Customer level Market level Facility level Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -33

Sensitivity analysis and CVP analysis • Sensitivity analysis – An approach that examines how an outcome may change due to variations in the predicted data or underlying assumptions Can be run using spreadsheet software, such as Excel • Goal seek approaches • – The analyst specifies the outcome, and the software specifies the necessary inputs • What-if analysis – The analyst specifies changes in assumptions and data to examine the effect of these changes on the outputs continued Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -34

Simple sensitivity analysis at Kubili. Time Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -35

Customer-related costs at Kubili. Time Pty Ltd Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -36

Profit model for Kubili. Time under activity-based costing Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -37

Real life • CVP analysis in the hotel sector – High occupancy rates – Lower fixed costs, IT & internet bookings has reduced the break-even occupancy rate • Reducing the break-even cost of mining gold at Gold Fields, was one of the reasons for the failed take-over attempt by Harmony of Gold Fields Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -38

Real life • Break-even at ATMS – – • Break-even of a major radiation medicine centre – – – • Advanced radiation and diagnostic equipment at cost of $96 m Revenue mix and number of patients International and local patients Break-even in the airline industry – – • Decision to install an ATM driven by its break-even Revenue depends on fees from the different types of transactions. Estimate the mix of transactions to determine the revenue mix Fixed costs include installation, rent & depreciation and planned maintenance Variable costs include paper, replacing deposit envelopes, variable component of communications costs and costs of physical cash management Break-even of A 380 increased from 270 to 420 planes for the Airbus Co. Boeing’s Dreamliner uses less fuel than comparable planes resulting in over 700 orders Both the A 380 and the Dreamliner have been subject to delays which increases the break-even number of planes Break-even load factor is about 70% but SAA moved from the Boeing 747 to the A 340 as SAA estimated that this would reduce the break-even load factor from 70% to 55% at the time. Break-even for wine producers in South Africa – – – Production cost (in 2001) amounted to R 9933 per hectare. If a farm achieves a recovery of 773 litres of wine per ton of grapes and if the farm was producing 10 tons per hectare, then the cost of production was about R 1. 28 per litre Add cellar costs of R 0. 93 per litre Yet the average selling price for bulk wine was about R 1. 25 per litre at the time. Break-even depends on the yield of grapes per hectare For branded bottled wines, we need to take into account the bottling costs, the marketing costs, storage and financing costs Copyright 2008 Mc. Graw-Hill PPTs t/a Management Accounting: Information for managing and creating value 1 e Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith 18 -39