CostVolumeProfit Analysis Chapter 7 1 Copyright 2008 Prentice

Objective 1 Calculate the unit contribution margin and the contribution margin ratio 2 Copyright

Components of CVP Analysis • • • Sales price per unit Volume sold Variable

CVP Assumptions 1. Change in volume is only factor that affects costs 2. Managers

Unit Contribution Margin Sales price per unit - Variable costs per unit Contribution margin

Contribution Margin Ratio Unit contribution margin Sales price per unit Example: Unit contribution margin

Objective 2 Use CVP analysis to find breakeven points and target profit volumes 7

Breakeven Point • Sales level at which operating income is zero • Sales above

Income Statement Approach Contribution Margin Income Statement Sales - Variable Costs Contribution Margin -

Short-Cut Approach Using the Unit Contribution Margin Units sold = Fixed expenses + Operating

Short-Cut Approach Using the Unit Contribution Margin Ratio Sales in $ = Fixed expenses

E 7 -15 1. Contribution margin ratio = Contribution margin ÷ Sales = $187,

E 7 -15 1. Hint: Contribution margin income statements are produced by using the

E 7 -15 2. Sales in $ = Fixed expenses + Operating income Contribution

E 7 -17 1. Contribution margin = Sales–Variable costs = $1. 70 - $0.

E 7 -17 2. Breakeven sales in units: Fixed costs + Operating income ?

E 7 -17 2. Breakeven sales in dollars: Fixed costs + Operating income Contribution

E 7 -17 3. Sales in units: Fixed costs + Operating income Contribution margin

Graphing the CVP Relationships Step 1: § Choose a sales volume § Plot point

Preparing a CVP Chart • 20 Copyright © 2008 Prentice Hall All rights reserved

Preparing a CVP Chart Step 2: § Draw the fixed cost line 21 Copyright

Preparing a CVP Chart 22 Copyright © 2008 Prentice Hall All rights reserved

Preparing a CVP Chart Step 3: § Draw the total cost line Hint: What

Preparing a CVP Chart 24 Copyright © 2008 Prentice Hall All rights reserved

Preparing a CVP Chart Step 4: § Identify the breakeven point and operating income

Preparing a CVP Chart Breakeven point 26 Copyright © 2008 Prentice Hall All rights

Preparing a CVP Chart Step 5: § Mark operating income and operating loss areas

Preparing a CVP Chart Breakeven point a r e p in g tin e

E 7 -24 s e u n e v Re 29 Copyright © 2008

E 7 -24 s e u n e v Re Fixed Costs 30 Copyright

E 7 -24 Breakeven point s e u n e v Re Total Costs

E 7 -24 s e u n ting e v Re era Total Costs

E 7 -24 ($24 x units sold)-($4 x units sold)-$24, 000 = $0 ($20

Objective 3 Perform sensitivity analysis in response to changing business conditions 34 Copyright ©

Sensitivity Analysis • • “What if” analysis What if the sales price changes? What

E 7 -25 Sales needed to Breakeven = Fixed Costs ÷ Contribution Margin Ratio

E 7 -26 Sale price per scarf $16 Contribution margin ratio Contribution margin per

Objective 4 Find breakeven and target profit volumes for multiproduct companies 39 Copyright ©

Multiple Product Break-Even Point – E 7 -28 Step 1: Calculate weighted-average contribution margin

Multiple Product Break-Even Point – E 7 -28 Step 2: Calculate the breakeven point

Multiple Product Break-Even Point – E 7 -28 Step 3: Calculate the breakeven point

E 7 -28 To earn $6, 600 Fixed costs + Operating income Weighted average

Objective 5 Determine a firm’s margin of safety and operating leverage 44 Copyright ©

Margin of Safety • Excess of expected sales over breakeven sales • Drop in

Margin of Safety in Units = Expected sales in units – Breakeven sales in

Margin of Safety Margin on safety as a percentage is the same whether units

E 7 -33 1. Margin of safety = Expected sales – breakeven sales Expected

E 7 -33 1. Margin of safety = Expected sales – breakeven sales Breakeven

E 7 -33 1. Margin of safety = Expected sales – breakeven sales =

E 7 -33 2. Margin of safety as a % of target sales =

Operating Leverage • Relative amount of fixed and variable costs that make up total

Characteristics of High Operating Leverage Firms • High operating leverage companies have: – Higher

Characteristics of Low Operating Leverage companies • Low operating leverage companies have: – Higher

Operating Leverage Factor Contribution margin Operating income As a general rule, the operating leverage

E 7 -33 3. Sales $70, 000 Variable costs (70%) 49, 000 Contribution margin

E 7 -33 4. If volume decreases 10%, income will decrease: 10% x 1.

End of Chapter 7 58 Copyright © 2008 Prentice Hall All rights reserved

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CVP Assumptions 1. Change in volume is only factor that affects costs 2. Managers can classify each cost as either variable or fixed • These costs are linear throughout relevant range 3. Revenues are linear throughout relevant range 4. Inventory levels will not change 5. The sales mix of products will not change 4 Copyright © 2008 Prentice Hall All rights reserved

Unit Contribution Margin Sales price per unit - Variable costs per unit Contribution margin per unit Example: Sales Price per Poster Less: Variable Cost per poster Contribution Margin per poster $35 (21) $14 5 Copyright © 2008 Prentice Hall All rights reserved

E 7 -15 1. Hint: Contribution margin income statements are produced by using the different volume levels and the calculated variable Statements expenses. Aussie Travel Contribution Margin Income Sales revenue $250, 000 $360, 000 Variable expenses (40%) 100, 000 144, 000 Contribution margin $? $? Fixed expenses 170, 000 Operating income (loss) $ (20, 000) $46, 000 13 Copyright © 2008 Prentice Hall All rights reserved

E 7 -17 1. Contribution margin = Sales–Variable costs = $1. 70 - $0. 85 = $0. 85 Contribution margin ratio: Contribution margin per unit = $0. 85 = 50% Sales price per unit $1. 70 15 Copyright © 2008 Prentice Hall All rights reserved

Graphing the CVP Relationships Step 1: § Choose a sales volume § Plot point for total sales revenue § Draw sales revenue line from origin through the plotted point 19 Copyright © 2008 Prentice Hall All rights reserved

Preparing a CVP Chart Step 4: § Identify the breakeven point and operating income and loss Hint: When the areas does a of company “break even”? When the neither make money or lose money…. 25 Copyright © 2008 Prentice Hall All rights reserved

E 7 -24 ($24 x units sold)-($4 x units sold)-$24, 000 = $0 ($20 x units sold) = $0 + $24, 000 Units sold = $24, 000 ÷ $20 = 1, 200, 000 tickets 1, 200, 000 x $24 per ticket = $28, 800, 000 33 Copyright © 2008 Prentice Hall All rights reserved

E 7 -25 Sales needed to Breakeven = Fixed Costs ÷ Contribution Margin Ratio $500, 000 = Fixed Costs ÷. 40 $500, 000 ×. 40= Fixed Costs $200, 000 = Fixed Costs New fixed costs = $240, 000 36 Copyright © 2008 Prentice Hall All rights reserved

E 7 -26 Sale price per scarf $16 Contribution margin ratio Contribution margin per unit x. 625 $10 Scarves needed to pay for extra entrance fee cost of $150 ($1, 000 x 15%): $150 ÷ $10 = 15 scarves 38 Copyright © 2008 Prentice Hall All rights reserved

Multiple Product Break-Even Point – E 7 -28 Step 1: Calculate weighted-average contribution margin Standard Chrome Sale price per unit $54 $78 Variable costs per unit 36 Contribution margin per unit Sales mix in units x 3 x 2 Contribution margin $54 $56 Weighted average contribution Margin per unit ($110 / 5) Total 50 $18 $28 $110 $22 40 Copyright © 2008 Prentice Hall All rights reserved

Multiple Product Break-Even Point – E 7 -28 Step 2: Calculate the breakeven point in units Fixed costs + Operating income Weighted average contribution margin per unit (? + ? ) ÷ ? = 440 composite units 41 Copyright © 2008 Prentice Hall All rights reserved

Multiple Product Break-Even Point – E 7 -28 Step 3: Calculate the breakeven point in units for each product line Standard: 440 units x 3/5 = 264 units Chrome: 440 units x 2/5 = 176 units 42 Copyright © 2008 Prentice Hall All rights reserved

E 7 -28 To earn $6, 600 Fixed costs + Operating income Weighted average contribution margin per unit ($9, 680 + $6, 600) ÷ $22 = 740 composite units Standard: 740 x 3/5 = 444 Chrome: 740 x 2/5 = 296 43 Copyright © 2008 Prentice Hall All rights reserved

Margin of Safety • Excess of expected sales over breakeven sales • Drop in sales that the company can absorb before incurring a loss • Used to evaluate the risk of current operations as well as the risk of new plans 45 Copyright © 2008 Prentice Hall All rights reserved

Margin of Safety in Units = Expected sales in units – Breakeven sales in units Margin of Safety in Dollars = Margin of safety in units x Sale price per unit 46 Copyright © 2008 Prentice Hall All rights reserved

Margin of Safety Margin on safety as a percentage is the same whether units or dollars are used Margin of safety in units ÷ Expected sales in units Margin of safety in dollars ÷ Expected sales in $ 47 Copyright © 2008 Prentice Hall All rights reserved

E 7 -33 1. Margin of safety = Expected sales – breakeven sales Expected sales: Sales – variable costs – fixed costs = operating income Sales – 70% Sales - $9, 000 = $12, 000 30% Sales = $9, 000 + $12, 000 Sales = $70, 000 48 Copyright © 2008 Prentice Hall All rights reserved

E 7 -33 1. Margin of safety = Expected sales – breakeven sales Breakeven sales: Sales – variable costs – fixed costs = operating income Sales - 70% x Sales - $9, 000 = $0 30% Sales = $9, 000 Sales = $30, 000 49 Copyright © 2008 Prentice Hall All rights reserved

Operating Leverage • Relative amount of fixed and variable costs that make up total costs • Operating leverage factor: Contribution margin Operating income Indicates percentage change in operating income that will occur from a 1% change in volume 52 Copyright © 2008 Prentice Hall All rights reserved

Characteristics of High Operating Leverage Firms • High operating leverage companies have: – Higher levels of fixed costs and lower levels of variable costs – Higher contribution margin ratios • For high operating leverage companies, changes in volume significantly affect operating income, so they also face: – Higher risk – Higher potential for reward • Examples include: golf courses, hotels, rental car agencies, theme parks, airlines, cruise lines 53 Copyright © 2008 Prentice Hall All rights reserved

Characteristics of Low Operating Leverage companies • Low operating leverage companies have: – Higher levels of variable costs, and lower levels of fixed costs – Lower contribution margin ratios • For low operating leverage companies, changes in volume do NOT have as significant an affect on operating income, so they face: – Lower risk – Lower potential for reward • Examples include: merchandising companies 54 Copyright © 2008 Prentice Hall All rights reserved

Operating Leverage Factor Contribution margin Operating income As a general rule, the operating leverage factor, at a given level of sales, indicates the percentage change in operating income that will occur from a 1% change in volume 55 Copyright © 2008 Prentice Hall All rights reserved

E 7 -33 3. Sales $70, 000 Variable costs (70%) 49, 000 Contribution margin $21, 000 Operating leverage: Contribution margin ÷ Operating income $21, 000 ÷ $12, 000 = 1. 75 56 Copyright © 2008 Prentice Hall All rights reserved