Cost-Volume-Profit Relationships

1. Cost-Volume-Profit Relationships

2. LEARNING OBJECTIVES 1. Explain how changes in activity affect contribution margin and net operating income. 2. Prepare and interpret a cost-volume-profit (CVP) graph. 3. Use the contribution margin (CM) ratio to compute changes in contribution margin and net operating income resulting from changes in sales volume. 4. Show the effects on contribution margin of changes in variable costs, fixed costs, selling price, and volume. 5. Compute the break-even point.

3. LEARNING OBJECTIVES 6. Determine the level of sales needed to achieve a desired target profit. 7. Use the margin of safety and explain its significance. 8. Compute the degree of operating leverage at a particular level of sales and explain how the degree of operating leverage can be used to predict changes to net operating income. 9. Compute the break-even point for a multiple-product company and explain the effects of shifts in the sales mix on contribution margin and the break-even point. 10. (Appendix 6A) Understand cost-volume-profit with uncertainty.

4. The Basics of Cost-Volume-Profit (CVP) Analysis

5. The Basics of Cost-Volume-Profit (CVP) Analysis

6. The Basics of Cost-Volume-Profit (CVP) Analysis

7. The Contribution Approach For each additional unit Wind sells, $200 more in contribution margin will help to cover fixed expenses and profit.

8. The Contribution Approach Each month Wind must generate at least $80,000 in total CM to break even.

9. The Contribution Approach If Wind sells 400 units in a month, it will be operating at the break-even point.

10. The Contribution Approach If Wind sells one additional unit (401 bikes), net income will increase by $200.

11. The Contribution Approach The break-even point can be defined either as: The point where total sales revenue equals total expenses (variable and fixed). The point where total contribution margin equals total fixed expenses.

12. CVP Relationships in Graphic Form Viewing CVP relationships in a graph gives managers a perspective that can be obtained in no other way. Consider the following information for Wind Co.:

13. CVP Graph

14. CVP Graph

15. CVP Graph

16. Contribution Margin Ratio The contribution margin ratio is:For Wind Bicycle Co. the ratio is:

17. Contribution Margin Ratio At Wind, each $1.00 increase in sales revenue results in a total contribution margin increase of 40¢. If sales increase by $50,000, what will be the increase in total contribution margin?

18. Contribution Margin Ratio

19. Contribution Margin Ratio

20. Changes in Fixed Costs and Sales Volume Wind is currently selling 500 bikes per month. The company’s sales manager believes that an increase of $10,000 in the monthly advertising budget would increase bike sales to 540 units. Should we authorize the requested increase in the advertising budget?

21. Changes in Fixed Costs and Sales Volume

22. Changes in Fixed Costs and Sales Volume The Shortcut Solution

23. APPLICATIONS OF CVP Consider the following basic data: Per unit Percent Sales Price $250 100 Less: Variable cost 150 60 Contribution margin 100 40 Fixed costs total $35,000

24. Change in Fixed Cost and Sales Volume Current sales are $100,000. Sales manager feels $10,000 increase in sales budget will provide $30,000 increase in sales. Should the budget be changed? Incremental CM approach: $30,000 x 40% CM ratio $12,000 Additional advertising expense 10,000 Increase in net income $2,000

25. Change in Variable Cost and Sales Volume Management is considering increasing quality of speakers at an additional cost of $10 per speaker and plan to sell 80 more units. Should management increase quality? Expected total CM = (480 speakers x $90) $43,200 Present total CM = (400 speakers x $100) 40,000 Increase in total contribution margin $3,200 (and net income)

26. Change in Fixed Cost, Sales Price and Sales Volume Management advises that if selling price dropped $20 per speaker and advertising increased by $15,000/month, sales would increase 50%. Good idea? Expected total CM = (400 x 150% x $80) $48,000 Present total CM (400 x $100) 40,000 Incremental CM 8,000 Additional advertising cost 15,000 Reduction in net income $(7,000)

27. Changes in Variable Cost, Fixed Cost, and Sales Volume A plan to switch salespeople from flat salary ($6,000 per month) to a sales commission of $15 per speaker could increase sales by 15%. Good idea? Expected total CM (400x115%x$85) $39,100 Current total CM (400 x $100) 40,000 Decrease in total CM (900) Salaries avoided if commission paid 6,000 Increase in net income $5,100

28. Change in Regular Sales Price A wholesaler is willing to buy 150 speakers if we will give him a discount off our price. The sale will not disturb regular sales and will not change fixed costs. We want to make $3,000 on this sale. What price should we quote? Variable cost per speaker $150 Desired profit on order (3,000/150) 20 Quoted price per speaker $170

29. Break-Even Analysis Break-even analysis can be approached in two ways: Equation method Contribution margin method.

30. Equation Method

31. Equation Method Here is the information from Wind Bicycle Co.:

32. Equation Method We calculate the break-even point as follows:

33. Equation Method We calculate the break-even point as follows:

34. Equation Method We can also use the following equation to compute the break-even point in sales dollars.

35. Equation Method We can also use the following equation to compute the break-even point in sales dollars.

36. Contribution Margin Method The contribution margin method is a variation of the equation method.

37. Target Profit Analysis Suppose Wind Co. wants to know how many bikes must be sold to earn a profit of $100,000.  We can use our CVP formula to determine the sales volume needed to achieve a target net profit figure.

38. The CVP Equation

39. The Contribution Margin Approach We can determine the number of bikes that must be sold to earn a profit of $100,000 using the contribution margin approach.

40. The Margin of Safety Excess of budgeted (or actual) sales over the break-even volume of sales. The amount by which sales can drop before losses begin to be incurred.

41. The Margin of Safety Wind has a break-even point of $200,000. If actual sales are $250,000, the margin of safety is $50,000 or 100 bikes.

42. The Margin of Safety The margin of safety can be expressed as 20 percent of sales.($50,000 ÷ $250,000)

43. Operating Leverage A measure of how sensitive net income is to percentage changes in sales. With high leverage, a small percentage increase in sales can produce a much larger percentage increase in net income.

44. Operating Leverage

45. Operating Leverage With a measure of operating leverage of 5, if Wind increases its sales by 10%, net income would increase by 50%.

46. Operating Leverage

47. The Concept of Sales Mix Sales mix is the relative proportions in which a company’s products are sold. Different products have different selling prices, cost structures, and contribution margins. Let’s assume Wind sells bikes and carts and see how we deal with break-even analysis.

48. The Concept of Sales Mix Wind Bicycle Co. provides us with the following information:

49. Assumptions of CVP Analysis Selling price is constant throughout the entire relevant range. Costs are linear throughout the entire relevant range. In multi-product companies, the sales mix is constant. In manufacturing companies, inventories do not change (units produced = units sold).

50. Cost-Volume-Profitwith Uncertainty

51. CVP with Uncertainty Use a decision tree to simplify calculations The decision tree is used to calculate profits under various alternatives A second decision tree can be used to calculate the probabilities of the various scenarios to further determine a reasonable estimate of profit A computer can be used to save time

52. End of Chapter 6