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## COST-VOLUME- PROFIT ANALYSIS

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**Cost-volume-profit (CVP) analysis is used to answer**questions such as: How much must I sell to earn my desired income? How will income be affectedif I reduce selling prices toincrease sales volume? What will happen toprofitability if I expandcapacity? Cost-Volume-Profit Relationships**Total fixed costextends horizontallyfrom the vertical axis.**Total fixed cost Preparing a CVP Graph • Starting at the origin, draw the total revenueline with a slope equal to the unit sales price. Revenue Costs and Revenuein Dollars Volume in Units**Preparing a CVP Graph**Revenue • Draw the total cost line with a slopeequal to the unit variable cost. Break-even Point Profit Costs and Revenuein Dollars Total cost Loss Total fixed cost Volume in Units**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**Computing Break-Even Point**How many units must this company sell to cover its fixed costs(break even)? How much contribution margin must this company have to cover its fixed costs (break even)? Answer: $30,000 How many units must this company sell to cover its fixed costs (break even)? Answer: $30,000 ÷ $20 per unit = 1,500 units Contribution margin is amount by which revenue exceeds the variable costs of producing the revenue. How much contribution margin must this company have to cover its fixed costs (break even)?**We have just seen one of the basic CVP relationships – the**break-evencomputation. Fixed costs Break-even point in units = Contribution margin per unit Formula for ComputingBreak-Even Sales (in Units) Finding the Break-Even Point Unit sales price less unit variable cost($20 in previous example)**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**Unit contribution = $5.00 - $3.00 = $2.00**Fixed costsUnit contribution $200,000$2.00 per unit = = 100,000 units Computing Break-Even Sales 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**Break-even formulas may be adjusted to show the sales volume**needed to earnany amount of operating income. Computing Sales Needed to Achieve Target Operating Income Unit sales in order to achieve target income Fixed costs + Target income = Contribution margin per unit**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**Unit contribution = $5.00 - $3.00 = $2.00**Fixed costs + Target income Unit contribution $200,000 + $40,000 $2.00 per unit = 120,000 units Computing Sales Needed to Achieve Target OperatingIncome 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**Fixed costs**Break-even point in dollars = Contribution margin ratio Contribution margin per unit Unit sales price Formula for ComputingBreak-Even Sales (in Dollars) The break-even formula may also be expressed in sales dollars.**Computing Break-Even Sales**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. $200,000 b. $300,000 c. $400,000 d. $500,000**Computing Break-Even Sales**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. $200,000 b. $300,000 c. $400,000 d. $500,000 Unit contribution = $5.00 - $3.00 = $2.00 Contribution margin ratio = $2.00 ÷ $5.00 = .40 = 40% Break-even revenue = $200,000 ÷ 40% = $500,000**Break-even formulas may be adjusted to show the sales volume**needed to earnany amount of operating income. Computing Sales Needed to Achieve Target Operating Income Unit sales in order to achieve target income Fixed costs + Target income = Contribution margin per unit Dollar sales in order to achieve target income Fixed costs + Target income = Contribution margin ratio**Margin of safety is the amount by which sales may decline**before reaching break-even sales: Margin of safety provides a quick means of estimating operating income at any level of sales: Margin of safety = Actual sales ($) - Break-even sales ($) Operating Margin Contribution Income of safety margin ratio = × What is our Margin of Safety?**ADM contribution margin ratio is 40 percent. If sales are**$100,000 and break-even sales are $80,000, what is operating income? Operating Margin Contribution Income of safety margin ratio = × Operating Income = $20,000 × .40 = $8,000 What is our Margin of Safety?**Once break-even is reached, every additional dollar of**contribution margin becomes operating income: ADM expects sales to increase by $15,000 and has a contribution margin ratio of 40%. How much will operating income increase? Change in Change in Contributionoperating income sales volume margin ratio = × Change in operating income = $15,000 × .40 = $6,000 What Change in Operating Income Do We Anticipate?**Income Taxes**Assuming that the motel’s tax rate is 45%. What operating income is required to achieve a $39,000 after-tax profit? Operating Income = Net Income (AT) / (100-Tax rate) = $39,000 / (100-45%) = $39,000 / (55%) = $70,909**Sales mix is the relative combination in whicha company’s**different products are sold. Different products have different selling prices, costs, and contribution margins. If Biken Inc. sells bikes and carts, howwill we deal with break-even analysis? CVP Analysis When a Company Sells Many Products**Biken Inc. provides us with the following information:**CVP Analysis When a Company Sells Many Products**The overall contribution margin ratio is:**$265,000 $550,000 CVP Analysis When a Company Sells Many Products = 48% (rounded)**Break-even in sales dollars is:**$170,000 .48 CVP Analysis When a Company Sells Many Products = $354,167 (rounded)**Consider the following information developed by the**accountant at Biken Inc., a bicycle retailer: Business Applications of CVP: Evaluating Marketing Strategy**Should Biken Inc. spend $12,000 on advertising to increase**sales by 10 percent? Business Applications of CVP**550 × $500**550 × $300 $80K + $12K Business Applications of CVP Should Biken Inc. spend $12,000 on advertising to increase sales by 10 percent?**Business Applications of CVP**Now, in combination with the advertising, Biken Inc. is considering a 10 percent price reduction that willincrease sales by 25 percent. What is the income effect?**1.25 × 500**625 × $450 625 × $300 $80K + $12K Business Applications of CVP Now, in combination with the advertising, Biken Inc. is considering a 10 percent price reduction that willincrease sales by 25 percent. What is the income effect?**Business Applications of CVP**Now, in combination with advertising and a price cut, Biken Inc.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 $92K - $50K Business Applications of CVP Now, in combination with advertising and a price cut, Biken Inc.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? The combination of advertising, a price cut,and change in compensation increases income.**Special orders**Scarce resources Make or buy decisions Sell, scrap or rebuild Incremental Analysis – Extension of CVP**Relevant Informationin Business Decisions**• Opportunity costs • Sunk costs • Out-of-pocket costs**The benefit that could have been attained by pursuing an**alternative course of action. Example: If you were not attending college, you could be earning $20,000 per year. Youropportunity cost of attending college for one year includes the $20,000. Opportunity Cost Opportunity costs are not recorded in the accounting records, but are relevant to decisions because they are a real sacrifice.**The decision to accept additional business should be based**on incremental costs andincremental revenues. Incremental amounts are those that occur only if the company decides to acceptthe new business. Special Order Decisions**View Co. currently sells 100,000 units of its product.**Special Order Decisions Should they accept an order of 10’000 units @ 8.50$ / unit?**If the order is accepted:**+ $5’000 of total overheads + $2’000 total selling expenses + $1,000 total administrative expenses Special Order Decisions**Special Order Decisions**First let’s look at incorrect reasoningthat leads to an incorrect decision. Our cost is $9.00per unit. I can’t sell for $8.50 per unit.**Special Order Decisions**This analysis leads to the correct decision.**Special Order Decisions**This analysis leads to the correct decision.**Special Order Decisions**This analysis leads to the correct decision.**10,000 new units × $8.50 selling price = $85,000**Special Order Decisions**10,000 new units × $3.50 = $35,000**Special Order Decisions**10,000 new units × $2.20 = $22,000**Special Order Decisions**Even though the $8.50 selling price is less than the**normal $10 selling price, View Co. should accept theoffer because net income will increase by $20,000. Special Order Decisions**We can also look at this decisionusing contribution margin.**Special Order Decisions**Production Constraint Decisions**Managers often face the problem of deciding how scarce resources are going to be utilized. Usually, fixed costs are not affected by this particular decision, so management can focus on maximizing total contribution margin. Let’s look at the Kaiser Company example.**Production Constraint Decisions**Machine A capacity 2’400 minutes per week**Machine A1 is the scarce resource because there is excess**capacity on other machines. Machine A1 is being used at 100% of its capacity. Machine A1 capacity is 2,400 minutes per week. Should Kaiser focus its efforts on Product 1 or 2? Production Constraint Decisions**Let’s calculate the contribution margin per unit of the**scarce resource, machine A1. Production Constraint Decisions