Chapter 4 CostVolumeProfit Analysis A Managerial Planning Tool

Chapter 4: Cost-Volume-Profit Analysis: A Managerial Planning Tool Cornerstones of Managerial Accounting, 4 e © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Break-Even Point 1 in Units and in Sales Dollars (continued) ► Companies use CVP analysis to help them reach important benchmarks, like breakeven point. ► The break-even point is the point where total revenue equals total cost (i. e. , the point of zero profit). ► Put another way, the break-even point is the level of sales at which contribution margin just covers fixed costs and consequently operating income is equal to zero. ► Since new companies typically experience losses (negative operating income) initially, they view their first break-even period as a significant milestone. $$$$ © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Using Operating Income in Cost-Volume-Profit Analysis For CVP analysis, it is useful to organize costs into fixed and variable components. Below is the income statement format that is based on the separation of Direct costs into fixed and variable components is called the materials contribution margin income statement. Direct labor Variable overhead Fixed overhead Variable selling and administrative costs Fixed selling and administrative costs © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Using Operating Income in Cost-Volume-Profit Analysis Contribution margin is the difference between sales and variable expense. It is the amount of sales revenue left over after all the variable expenses are covered that can be used to contribute to fixed expense and operating income. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Break-Even Point in Units If the contribution margin income statement is recast as an equation, it becomes more useful for solving CVP problems. Basic CVP Equation © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Break-Even Point in Units (continued) To recap, the break-even units are equal to the fixed cost divided by the contribution margin per unit. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Break-Even Point in Sales Dollars Sometimes, managers using CVP analysis may prefer to use sales revenue as the measure of sales activity instead of units sold. A units sold measure can be converted to a sales revenue measure by multiplying the unit selling price by the units sold: For example, the break-even point for Whittier is 600 mowers; the selling cost is $400 per mower. So, Breakeven in Sales $’s = 600 x $400 = $240, 000 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Variable Cost Ratio and Contribution Margin Ratio Any answer expressed in units sold can be easily converted to one expressed in sales revenues. Variable Cost Ratio Contribution Margin Ratio Alternatively: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fixed Cost’s Relationship with the Variable Cost Ratio and the Contribution Margin Ratio 1 ► Since the total contribution margin is the revenue remaining after total variable costs are covered, it must be the revenue available to cover fixed costs and contribute to profit. How does the relationship of fixed cost to contribution margin affect operating income? ► There are three possibilities: ► Fixed cost equals contribution margin; operating income is zero; the company breaks even. ► Fixed cost is less than contribution margin; operating income is greater than zero; the company makes a profit. ► Fixed cost is greater than contribution margin; operating income is less than zero; the company makes a loss. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Units to Be Sold to Achieve a Target Income ► While the break-even point is useful information and an important benchmark for relatively young companies, most companies would like to earn operating income greater than $0. ► CVP allows us to do this by adding the target income amount to the fixed cost. ► First, let’s look in terms of units that must be sold. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Sales Revenue to Achieve a Target Income ► How much sales revenue must Whittier generate to earn an operating income of $37, 500? This question is similar to the one we asked earlier in terms of units but phrases the question directly in terms of sales revenue. ► To answer the question, add the targeted operating income of $37, 500 to the $45, 000 of fixed cost and divide by the contribution margin ratio. This equation is: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Impact of Change in Revenue on Change in Profit ► Assuming that fixed costs remain unchanged, the contribution margin ratio can be used to find the profit impact of a change in sales revenue. ► To obtain the total change in profits from a change in revenues, multiply the contribution margin ratio times the change in sales: Change in Profits Contribution Change = Margin in x Ratio Sales © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Graphs of Cost-Volume-Profit Relationships: The Profit-Volume Graph 3 A profit-volume graph visually portrays the relationship between profits (operating income) and units sold. ► The profit-volume graph is the graph of the operating income equation: Operating income = (Price x Units) - (Unit variable cost x Units) - Total fixed cost ► In this graph, operating income is the dependent variable, and units is the independent variable. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Graphs of Cost-Volume-Profit 3 Relationships: The Cost-Volume-Profit Graph The cost-volume-profit graph depicts the relationships among cost, volume, and profits (operating income). © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 CVP Analysis Assumptions Major assumptions of CVP analysis include: 1 2 Linear revenue and cost functions remain constant over the relevant range. Selling prices and costs are known with certainty. 3 4 All units produced are sold; no finished goods inventories remain. Sales mix is known with certainty for multipleproduct break-even settings. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Multiple-Product Analysis ► Cost-volume-profit analysis is fairly simple in the singleproduct setting. However, most firms produce and sell a number of products or services. ► How do we adapt the formulas used in a single-product setting to a multiple-product setting? ► One important distinction is to separate direct fixed expenses from common fixed expenses. ►Direct fixed expenses are those fixed costs that can be traced to each segment and would be avoided if the segment did not exist. ►Common fixed expenses are the fixed costs that are not traceable to the segments and would remain even if one of the segments was eliminated. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Break-Even Calculations for Multiple Products ►When more than one product is produced and sold, managers must estimate the sales mix and calculate a package contribution margin. ►Sales mix is the relative combination of products being sold by a firm. Fixed Costs Break-Even Packages = Package Contribution Margin © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 Cost-Volume-Profit Analysis and Risk and Uncertainty Managers must be aware of so many factors in our dynamic world. CVP analysis is a tool that managers use to handle risk and uncertainty. ? Risks? s in e g n Cha es? ? pric ? ty e in a t r c Un Fixed ? costs? ? Variable costs? ? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 Methods to Deal with Uncertainty and Risk 1 • Management must realize the uncertain nature of future prices, costs, and quantities. 2 • Management must assume a breakeven “band” rather than a breakeven point. 3 • Managers should use sensitivity or “what-if” analyses. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 Margin of Safety ►The margin of safety is the units sold or the revenue earned above the break-even volume. ►For example, if the break-even volume for a company is 200 units and the company is currently selling 500 units, the margin of safety in units is: Sales - Breakeven units = 500 – 200 = 300 units ►If the break-even volume for a company is $200, 000 and the current revenues are $500, 000, the margin of safety in sales revenue is: Revenue - Break-even volume = $500, 000 – 200, 000 = $300, 000 ►The margin of safety as a percentage of total sales dollars can then be expressed as: Margin of safety ÷ Revenues = $300, 000 ÷ $500, 000 = 60% © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 Operating Leverage ►Operating leverage is the use of fixed costs to extract higher percentage changes in profits as sales activity changes. ►Operating leverage is the measure of the proportion of fixed costs in a company’s cost structure. ►It is used as an indicator of how sensitive profit is to changes in sales volume. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 Operating Leverage (continued) ►The degree of operating leverage (DOL) can be measured for a given level of sales by taking the ratio of contribution margin to operating income or: Contribution margin ÷ Operating income © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 Summary of Operating Leverage HIGH LOW % profit increase with sales increase Large Small % loss increase with sales decrease Large Small © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 Sensitivity Analysis © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.