CostVolumeProfit Analysis Chapter 3 2009 Foster Business School

Cost-Volume-Profit Analysis Chapter 3 2009 Foster Business School Cost Accounting L. Du. Charme 1

Outline • CVP assumptions & terminology • BEP solution – Target operating income – Target net income • Margin of Safety • Operating Leverage • CM vs. GM 2009 Foster Business School Cost Accounting L. Du. Charme 2

Asumptions Four assumptions underlying cost-volume-profit (CVP) analysis are presented in the text. We will assume that they hold here. 2009 Foster Business School Cost Accounting L. Du. Charme 3

Cost-Volume-Profit Terminology Operating income = Total revenues from operations – Cost of goods sold and operating costs (excluding income taxes) Net income = Operating income – Income taxes 2009 Foster Business School Cost Accounting L. Du. Charme 4

(CVP) Analysis Example Assume that the Pants Shop can purchase pants for $32 from a local factory; other variable costs amount to $10 per unit. The local factory allows the Pants Shop to return all unsold pants and receive a full $32 refund per pair of pants within one year. The average selling price per pair of pants is $70 and total fixed costs amount to $84, 000. 2009 Foster Business School Cost Accounting L. Du. Charme 5

(CVP) Analysis Example How much revenue will the business receive if 2, 500 units are sold? 2, 500 × $70 = $175, 000 How much variable costs will the business incur? 2, 500 × $42 = $105, 000 $175, 000 – 105, 000 – 84, 000 = ($14, 000) 2009 Foster Business School Cost Accounting L. Du. Charme 6

(CVP) Analysis Example What is the contribution margin per unit? $70 – $42 = $28 contribution margin per unit What is the total contribution margin when 2, 500 pairs of pants are sold? 2, 500 × $28 = $70, 000 2009 Foster Business School Cost Accounting L. Du. Charme 7

(CVP) Analysis Example Contribution margin percentage (contribution margin ratio) is the contribution margin per unit divided by the selling price. What is the contribution margin percentage? $28 ÷ $70 = 40% 2009 Foster Business School Cost Accounting L. Du. Charme 8

(CVP) Analysis Example If the business sells 3, 000 pairs of pants, revenues will be $210, 000 and contribution margin would equal 40% × $210, 000 = $84, 000. 2009 Foster Business School Cost Accounting L. Du. Charme 9

BEPs Determine the breakeven point and output level needed to achieve a target operating income using: (1) the equation, (2) contribution margin, and (3) graph methods. 2009 Foster Business School Cost Accounting L. Du. Charme 10

Breakeven Point Sales – Variable expenses = Fixed expenses Total revenues = Total costs Rev – VC – FC = 0 2009 Foster Business School Cost Accounting L. Du. Charme 11

Abbreviations SP = Selling price VCU = Variable cost per unit CMU = Contribution margin per unit CM% = Contribution margin percentage FC = Fixed costs 2009 Foster Business School Cost Accounting L. Du. Charme 12

Abbreviations Q = Quantity of output units sold (and manufactured) OI = Operating income TOI = Target operating income TNI = Target net income (after tax) 2009 Foster Business School Cost Accounting L. Du. Charme 13

Equation Method (Selling price × Quantity sold) – (Variable unit cost × Quantity sold) – Fixed costs = Operating income Let Q = number of units to be sold to break even $70 Q – $42 Q – $84, 000 = 0 $28 Q = $84, 000 ÷ $28 = 3, 000 units 2009 Foster Business School Cost Accounting L. Du. Charme 14

Contribution Margin Method $84, 000 ÷ $28 = 3, 000 units $84, 000 ÷ 40% = $210, 000 2009 Foster Business School Cost Accounting L. Du. Charme 15

Graph Method Breakeven e u n e v e R ts s o c l Tota Fixed costs 2009 Foster Business School Cost Accounting L. Du. Charme 16

Target Operating Income (Fixed costs + Target operating income) divided either by Contribution Margin percentage or Contribution Margin per unit 2009 Foster Business School Cost Accounting L. Du. Charme 17

Target Operating Income Assume that management wants to have an operating income of $14, 000. How many pairs of pants must be sold? ($84, 000 + $14, 000) ÷ $28 = 3, 500 What dollar sales are needed to achieve this income? ($84, 000 + $14, 000) ÷ 40% = $245, 000 2009 Foster Business School Cost Accounting L. Du. Charme 18

Income Taxes Understand how income taxes affect CVP analysis. 2009 Foster Business School Cost Accounting L. Du. Charme 19

Target Net Income and Income Taxes Example Management would like to earn an after tax income of $35, 711. The tax rate is 30%. What is the target operating income? Target operating income = Target net income ÷ (1 – tax rate) TOI = $35, 711 ÷ (1 – 0. 30) = $51, 016 2009 Foster Business School Cost Accounting L. Du. Charme 20

Target Net Income and Income Taxes Example How many units must be sold? Revenues – Variable costs – Fixed costs = Target net income ÷ (1 – tax rate) $70 Q – $42 Q – $84, 000 = $35, 711 ÷ 0. 70 $28 Q = $51, 016 + $84, 000 Q = $135, 016 ÷ $28 = 4, 822 pairs of pants 2009 Foster Business School Cost Accounting L. Du. Charme 21

Target Net Income and Income Taxes Example Proof: Revenues: 4, 822 × $70 Variable costs: 4, 822 × $42 Contribution margin Fixed costs Operating income Income taxes: $51, 016 × 30% Net income 2009 Foster Business School Cost Accounting L. Du. Charme $337, 540 202, 524 $135, 016 84, 000 51, 016 15, 305 $ 35, 711 22

Operating Leverage Operating leverage describes the effects that fixed costs have on changes in operating income as changes occur in units sold. Organizations with a high proportion of fixed costs have high operating leverage. 2009 Foster Business School Cost Accounting L. Du. Charme 23

Operating Leverage Example Degree of operating leverage = Contribution margin ÷ Operating income What is the degree of operating leverage of the Pants Shop at the 3, 500 sales level under two different arrangements? Existing arrangement: 3, 500 × $28 = $98, 000 contribution margin 2009 Foster Business School Cost Accounting L. Du. Charme 24

Operating Leverage Example $98, 000 contribution margin – $84, 000 fixed costs = $14, 000 operating income $98, 000 ÷ $14, 000 = 7. 0 New arrangement: Assume Unit Variable Costs = $35 and Fixed Cost = $114, 000 3, 500 × $35 = $122, 500 contribution margin 2009 Foster Business School Cost Accounting L. Du. Charme 25

Operating Leverage Example $122, 500 contribution margin – $114, 000 fixed costs = $8, 500 $122, 500 ÷ $8, 500 = 14. 4 The degree of operating leverage at a given level of sales helps managers calculate the effect of fluctuations in sales on operating income. E. g. , above: a 10% increase in sales will yield a 144% increase in op. income! What is operating leverage if fixed costs = 0? As sales increase, what happens to op. leverage? 2009 Foster Business School Cost Accounting L. Du. Charme 26

Contribution Margin versus Gross Margin Contribution income statement emphasizes contribution margin. Financial accounting income statement emphasizes gross margin. 2009 Foster Business School Cost Accounting L. Du. Charme 27

GM versus CM • The difference between GM and CM all is in how you account for: – Fixed mfg. costs (in Co. GS, NOT in VC) – Variable non-mfg. costs (in VC, NOT in Co. GS) GM = Rev. – Co. GS CM = Rev. – VC “Margins” are usually referred to in finance. What margins are they usually referring to? 2009 Foster Business School Cost Accounting L. Du. Charme 28

End of Chapter 3 2009 Foster Business School Cost Accounting L. Du. Charme 29