Chapter 2 CostVolumeProfit Analysis Questions Addressed by CostVolumeProfit

Chapter 2 Cost-Volume-Profit Analysis

Questions Addressed by Cost-Volume-Profit Analysis CVP analysis is used to answer questions such as: How much must I sell to earn my desired income? v How will income be affected if I reduce selling prices to increase sales volume? v What will happen to profitability if I expand capacity? v

Total Fixed Cost Monthly Basic Telephone Bill Total fixed costs remain unchanged when activity changes. Number of Local Calls Your monthly basic telephone bill probably does not change when you make more local calls.

Fixed Cost Per Unit Your average cost per local call decreases as more local calls are made. Monthly Basic Telephone Bill per Local Call Fixed costs per unit decline as activity increases. Number of Local Calls

Total Variable Cost Total Long Distance Telephone Bill Total variable costs change when activity changes. Minutes Talked Your total long distance telephone bill is based on how many minutes you talk.

Variable Cost Per Unit The cost per long distance minute talked is constant. For example, 10 cents per minute. Per Minute Telephone Charge Variable costs per unit do not change as activity increases. Minutes Talked

Cost Behavior Summary

Mixed Costs Mixed costs contain a fixed portion that is incurred even when facility is unused, and a variable portion that increases with usage. Example: monthly electric utility charge l l Fixed service fee Variable charge per kilowatt hour used

Total Utility Cost Mixed Costs Slope is variable cost per unit of activity. l a t o d e x mi st o c T Variable Utility Charge Fixed Monthly Utility Charge Activity (Kilowatt Hours)

Stair-Step Costs Cost Total cost remains constant within a narrow range of activity. Activity

Stair-Step Costs Cost Total cost increases to a new higher cost for the next higher range of activity. Activity

Curvilinear Costs Total Cost Curvilinear Cost Function Relevant Range Volume of Output A straight line closely (constant unit variable cost) approximates a curvilinear variable cost line within the relevant range.

Cost-Volume-Profit (CVP) Analysis Let’s extend our knowledge of cost behavior to CVP analysis.

Computing Break-Even Point The break-even point (expressed in units of product or dollars of sales) is the unique sales level at which a company neither earns a profit nor incurs a loss.

Computing Break-Even Point Contribution margin is amount by which revenue exceeds the variable costs of producing the revenue.

Computing Break-Even Point How much contribution margin must this company have to cover its fixed costs (break even)?

Computing Break-Even Point How much contribution margin must this company have to cover its fixed costs (break even)? Answer: $30, 000

Computing Break-Even Point How many units must this company sell to cover its fixed costs (break even)?

Computing Break-Even Point How many units must this company sell to cover its fixed costs (break even)? Answer: $30, 000 ÷ $20 per unit = 1, 500 units

Formula for Computing Finding the Break-Even Point Break-Even Sales (in Units) We have just seen one of the basic CVP relationships – the break-even computation. Break-even point in units = Fixed costs Contribution margin per unit Unit sales price less unit variable cost ($20 in previous example)

Formula for Computing Break-Even Sales (in Dollars) The break-even formula may also be expressed in sales dollars. Break-even point in dollars = Fixed costs Contribution margin ratio Unit sales price Unit variable cost

Computing Break-Even Sales Question 1 ABC Co. sells product XYZ at $5. 00 per unit. If fixed costs are $200, 000 and variable costs are $3. 00 per unit, how many units must be sold to break even? a. 100, 000 units b. 40, 000 units c. 200, 000 units d. 66, 667 units

Computing Break-Even Sales Question 1 ABC Co. sells product XYZ at $5. 00 per unit. If fixed costs are $200, 000 and variable costs are $3. 00 per unit, how many units must be sold to break even? a. 100, 000 units Unit contribution = $5. 00 - $3. 00 = $2. 00 b. 40, 000 units c. 200, 000 units. Fixed costs $200, 000 = $2. 00 per unit Unit contribution d. 66, 667 units = 100, 000 units

Computing Break-Even Sales Question 2 Use the contribution margin ratio formula to determine the amount of sales revenue ABC must have to break even. All information remains unchanged: fixed costs are $200, 000; unit sales price is $5. 00; and unit variable cost is $3. 00. a. b. c. d. $200, 000 $300, 000 $400, 000 $500, 000

Computing Break-Even Sales Question 2 Use the contribution margin ratio formula to determine the amount of sales revenue ABC must have to break even. All information remains unchanged: fixed costs are $200, 000; unit sales price is $5. 00; and unit variable cost is $3. 00. Unit contribution = $5. 00 - $3. 00 = $2. 00 a. b. c. d. $200, 000 Contribution margin ratio = $2. 00 ÷ $5. 00 =. 40 $300, 000 Break-even revenue = $200, 000 ÷. 4 = $500, 000 $400, 000 $500, 000

Preparing a CVP Graph ŒStarting at the origin, draw the total revenue Costs and Revenue in Dollars line with a slope equal to the unit sales price. Revenue Total fixed cost extends horizontally from the vertical axis. Total fixed cost Volume in Units

Preparing a CVP Graph Draw the total cost line with a slope Revenue Costs and Revenue in Dollars equal to the unit variable cost. Break-even Point Profit Total cost Loss Total fixed cost Volume in Units

Computing Sales Needed to Achieve Target Operating Income Break-even formulas may be adjusted to show the sales volume needed to earn any amount of operating income. Unit sales = Fixed costs + Target income Contribution margin per unit Fixed costs + Target income Dollar sales = Contribution margin ratio

Computing Sales Needed to Achieve Target Operating Income ABC Co. sells product XYZ at $5. 00 per unit. If fixed costs are $200, 000 and variable costs are $3. 00 per unit, how many units must be sold to earn operating income of $40, 000? a. 100, 000 units b. 120, 000 units c. 80, 000 units d. 200, 000 units

Computing Sales Needed to Achieve Target Operating Income ABC Co. sells product XYZ at $5. 00 per unit. If fixed costs are $200, 000 and variable costs are $3. 00 per unit, how many units must be sold to earn operating income of $40, 000? Unit contribution = $5. 00 - $3. 00 = $2. 00 a. 100, 000 units Fixed costs + Target income b. 120, 000 units Unit contribution c. 80, 000 units$200, 000 + $40, 000 = 120, 000 units d. 200, 000 units $2. 00 per unit

What is our Margin of Safety? Margin of safety is the amount by which sales may decline before reaching break-even sales: Margin of safety = Actual sales - Break-even sales Margin of safety provides a quick means of estimating operating income at any level of sales: Operating Income = Margin of safety × Contribution margin ratio

What is our Margin of Safety? Oxco’s contribution margin ratio is 40 percent. If sales are $100, 000 and breakeven sales are $80, 000, what is operating income? Operating Income Margin of safety = Operating Income = $20, 000 ×. 40 = $8, 000 × Contribution margin ratio

What Change in Operating Income Do We Anticipate? Once break-even is reached, every additional dollar of contribution margin becomes operating income: Change in operating income = Change in Contribution sales volume × margin ratio Oxco expects sales to increase by $15, 000. How much will operating income increase? Change in operating income = $15, 000 ×. 40 = $6, 000

Business Applications of CVP

Business Applications of CVP Consider the following information developed by the accountant at Cycl. Co, a bicycle retailer:

Business Applications of CVP Should Cycl. Co spend $12, 000 on advertising to increase sales by 10 percent?

Business Applications of CVP Should Cycl. Co spend $12, 000 on advertising to increase sales by 10 percent? 550 × $500 550 × $300 $80 K + $12 K No, income is decreased.

Business Applications of CVP Now, in combination with the advertising, Cycl. Co is considering a 10 percent price reduction that will increase sales by 25 percent. What is the income effect?

Business Applications of CVP Now, in combination with the advertising, Cycl. Co is considering a 10 percent price reduction that will increase sales by 25 percent. What is the income effect? 1. 25 × 500 625 × $450 625 × $300 $80 K + $12 K Income is decreased even more.

Business Applications of CVP Now, in combination with advertising and a price cut, Cycl. Co will replace $50, 000 in sales salaries with a $25 per bike commission, increasing sales by 50 percent above the original 500 bikes. What is the effect on income?

Business Applications of CVP Now, in combination with advertising and a price cut, Cycl. Co will replace $50, 000 in sales salaries with a $25 per bike commission, increasing sales by 50 percent above the original 500 bikes. What is the effect on income? 1. 5 × 500 750 × $450 750 × $325 $92 K - $50 K The combination of advertising, a price cut, and change in compensation increases income.

Additional Considerations in CVP ŒDifferent products with different contribution margins. Determining semivariable cost elements. Complying with the assumptions of CVP analysis.

CVP Analysis When a Company Sells Many Products Sales mix is the relative combination in which a company’s different products are sold. Different products have different selling prices, costs, and contribution margins. If Cycl. Co sells bikes and carts, how will we deal with break-even analysis?

CVP Analysis When a Company Sells Many Products Cycl. Co provides us with the following information:

CVP Analysis When a Company Sells Many Products The overall contribution margin ratio is: $265, 000 $550, 000 = 48% (rounded)

CVP Analysis When a Company Sells Many Products Break-even in sales dollars is: $170, 000. 48 = $354, 167 (rounded)

The High-Low Method Owl. Co recorded the following production activity and maintenance costs for two months: Using these two levels of activity, compute: Πthe variable cost per unit. the total fixed cost. total cost formula.

The High-Low Method in cost ŒUnit variable cost = in units = $3, 600 4, 000 = $0. 90 per unit

The High-Low Method $3, 600 in cost ŒUnit variable cost = in units = 4, 000 = $0. 90 per unit Fixed cost = Total cost – Total variable cost

The High-Low Method $3, 600 in cost ŒUnit variable cost = in units = 4, 000 = $0. 90 per unit Fixed cost = Total cost – Total variable cost Fixed cost = $9, 700 – ($0. 90 per unit × 9, 000 units) Fixed cost = $9, 700 – $8, 100 = $1, 600

The High-Low Method $3, 600 in cost ŒUnit variable cost = in units = 4, 000 = $0. 90 per unit Fixed cost = Total cost – Total variable cost Fixed cost = $9, 700 – ($0. 90 per unit × 9, 000 units) Fixed cost = $9, 700 – $8, 100 = $1, 600 Total cost = $1, 600 + $. 90 per unit

The High-Low Method Question 1 If sales commissions are $10, 000 when 80, 000 units are sold and $14, 000 when 120, 000 units are sold, what is the variable portion of sales commission per unit sold? a. b. c. d. $. 08 per unit $. 10 per unit $. 125 per unit

The High-Low Method Question 1 If sales commissions are $10, 000 when 80, 000 units are sold and $14, 000 when 120, 000 units are sold, what is the variable portion of sales commission per unit sold? a. b. c. d. $. 08 per unit $. 10 per unit $. 125 per unit $4, 000 ÷ 40, 000 units = $. 10 per unit

The High-Low Method Question 2 If sales commissions are $10, 000 when 80, 000 units are sold and $14, 000 when 120, 000 units are sold, what is the fixed portion of the sales commission? a. b. c. d. $ 2, 000 $ 4, 000 $10, 000 $12, 000

The High-Low Method Question 2 If sales commissions are $10, 000 when 80, 000 units are sold and $14, 000 when 120, 000 units are sold, what is the fixed portion of the sales commission? a. b. c. d. $ 2, 000 $ 4, 000 $10, 000 $12, 000

Assumptions Underlying CVP Analysis ΠA limited range of activity, called the relevant range, where CVP relationships are linear. v. Unit selling price remains constant. v. Unit variable costs remain constant. v. Total fixed costs remain constant. Sales mix remains constant. Production = sales (no inventory changes).

End of Chapter 2