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Cost-Volume-Profit Analysis

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  1. Chapter19 Cost-Volume-Profit Analysis

  2. CVP analysis is used to answer questionssuch 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? Questions Addressed byCost-Volume-Profit Analysis

  3. Total Fixed Cost Total fixed costs remain unchangedwhen activity changes. Monthly Basic Telephone Bill Your monthly basictelephone bill probablydoes not change whenyou make more local calls. Number of Local Calls

  4. Fixed costs per unit declineas activity increases. Fixed Cost Per Unit Monthly Basic Telephone Bill per Local Call Your average cost perlocal call decreases asmore local calls are made. Number of Local Calls

  5. Total Variable Cost • Total variable costs changewhen activity changes. Total Long DistanceTelephone Bill Your total long distancetelephone bill is basedon how many minutesyou talk. Minutes Talked

  6. Variable costs per unit do not changeas activity increases. Variable Cost Per Unit Per MinuteTelephone Charge The cost per long distanceminute talked is constant.For example, 10cents per minute. Minutes Talked

  7. Cost Behavior Summary

  8. Mixed costs contain a fixed portion that is incurred even when facility is unused, and a variable portion that increases with usage. Example: monthly electric utility charge Fixed service fee Variable charge perkilowatt hour used Mixed Costs

  9. Mixed Costs Slope isvariable costper unitof activity. Total mixed cost Variable Utility Charge Total Utility Cost Fixed MonthlyUtility Charge Activity (Kilowatt Hours)

  10. Stair-Step Costs Total cost remainsconstant within anarrow range ofactivity. Cost Activity

  11. Stair-Step Costs Total cost increases to a new higher cost for the next higher range of activity. Cost Activity

  12. Relevant Range Curvilinear Costs CurvilinearCost Function A straight line closely (constant unit variable cost)approximates acurvilinear variablecost line withinthe relevant range. Total Cost Volume of Output

  13. Cost-Volume-Profit(CVP) Analysis Let’s extend ourknowledge ofcost behavior to CVP analysis.

  14. 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

  15. Computing Break-Even Point Contribution margin is amount by which revenue exceeds the variable costs of producing the revenue.

  16. Computing Break-Even Point How much contribution margin must this company have to cover its fixed costs (break even)?

  17. Computing Break-Even Point How much contribution margin must this company have to cover its fixed costs (break even)? Answer: $30,000

  18. Computing Break-Even Point How many units must this company sell to cover its fixed costs (break even)?

  19. Computing Break-Even Point How many units must this company sell to cover its fixed costs (break even)? Answer: $30,000 ÷ $20 per unit = 1,500 units

  20. We have just seen one of the basic CVP relationships – thebreak-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)

  21. Unit sales price Unit variable cost Formula for ComputingBreak-Even Sales (in Dollars) The break-even formula may also be expressed in sales dollars. Fixed costs Break-even point in dollars = Contribution margin ratio

  22. 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 SalesQuestion 1

  23. Computing Break-Even SalesQuestion 1 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 Unit contribution = $5.00 - $3.00 = $2.00 Fixed costsUnit contribution $200,000$2.00 per unit = = 100,000 units

  24. Computing Break-Even SalesQuestion 2 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

  25. Computing Break-Even SalesQuestion 2 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 Break-even revenue = $200,000 ÷ .4 = $500,000

  26. 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

  27. Preparing a CVP Graph • Draw the total cost line with a slopeequal to the unit variable cost. Revenue Break-even Point Profit Costs and Revenuein Dollars Total cost Loss Total fixed cost Volume in Units

  28. 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 Fixed costs + Target income Unit sales = Contribution margin per unit Fixed costs + Target income Dollar sales = Contribution margin ratio

  29. 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

  30. 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 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

  31. 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?

  32. Oxco’s 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?

  33. Once break-even is reached, every additional dollar of contribution margin becomes operating income: Oxco expects sales to increase by $15,000. 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?

  34. Business Applications of CVP

  35. Consider the following information developed by the accountant at CyclCo, a bicycle retailer: Business Applications of CVP

  36. Should CyclCo spend $12,000 on advertising to increase sales by 10 percent? Business Applications of CVP

  37. $80K + $12K Business Applications of CVP Should CyclCo spend $12,000 on advertising to increase sales by 10 percent? 550 × $500 550 × $300 No, income is decreased.

  38. Business Applications of CVP Now, in combination with the advertising, CyclCo is considering a 10 percent price reduction that willincrease sales by 25 percent. What is the income effect?

  39. $80K + $12K Business Applications of CVP Now, in combination with the advertising, CyclCo 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 Income is decreased even more.

  40. Business Applications of CVP Now, in combination with advertising and a price cut, CyclCowill 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?

  41. $92K - $50K Business Applications of CVP Now, in combination with advertising and a price cut, CyclCowill 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 The combination of advertising, a price cut,and change in compensation increases income.

  42. Different products with different contribution margins. • Determining semivariablecost elements. • Complying with theassumptions of CVP analysis. Additional Considerations in CVP

  43. 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 CyclCo sells bikes and carts, howwill we deal with break-even analysis? CVP Analysis When a Company Sells Many Products

  44. CyclCo provides us with the following information: CVP Analysis When a Company Sells Many Products

  45. The overall contribution margin ratio is: CVP Analysis When a Company Sells Many Products $265,000 $550,000 = 48% (rounded)

  46. Break-even in sales dollars is: CVP Analysis When a Company Sells Many Products $170,000 .48 = $354,167 (rounded)

  47. OwlCo recorded the following production activity and maintenance costs for two months: Using these two levels of activity, compute: the variable cost per unit. the total fixed cost. total cost formula. The High-Low Method

  48. The High-Low Method $3,600 4,000 in costin units • Unit variable cost = = = $0.90 per unit

  49. The High-Low Method $3,600 4,000 in costin units • Unit variable cost = = = $0.90 per unit • Fixed cost = Total cost – Total variable cost

  50. The High-Low Method $3,600 4,000 in costin units • Unit variable cost = = = $0.90 per unit • Fixed cost = Total cost – Total variable cost • Fixed cost = $9,700 – ($0.90 per unit × 9,000 units) • Fixed cost = $9,700 – $8,100 = $1,600