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Cost-Volume-Profit Analysis

Cost-Volume-Profit Analysis. Chapter 22. HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT. Objectives. 1. Identify different cost behaviour patterns 2. Use a contribution margin statement of financial performance to make business decisions

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Cost-Volume-Profit Analysis

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  1. Cost-Volume-Profit Analysis Chapter 22 HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT

  2. Objectives 1. Identify different cost behaviour patterns 2. Use a contribution margin statement of financial performance to make business decisions 3. Calculate breakeven sales 4. Calculate the sales level needed to earn a target profit

  3. Objectives 5. Graph a set of cost-volume-profit relationships 6. Calculate a margin of safety 7. Use the sales mix in CVP analysis 8. Calculate profit using variable costing and absorption costing

  4. Identify different cost behavior patterns. Objective 1

  5. Types of Costs Variable Fixed Mixed

  6. Variable Costs Example • Consider the textbook example of North Coast Railway • Assume that breakfast costs the railway $3 per person. • If the railway carries 2,000 passengers, it will spend $6,000 for breakfast.

  7. Variable Costs Example Total Variable Costs (thousands) $24 – $18 – $12 – $6 – – – – – 0 1 2 3 4 5 Volume (Thousands of passengers)

  8. Fixed Costs Example $400 – $300 – $200 – $100 – Total Fixed Costs (thousands) – – – – 0 1 2 3 4 5 Volume (Thousands of passengers)

  9. Mixed Costs Example • A mixed cost is part variable and part fixed. • Assume the railway’s internet service has fixed costs of $50 per month ($600 per year) and there are also variable costs of $3 per hour of use.

  10. Mixed Costs Example $2,850 – $2,100 – $1,350 – $600 – Total Costs Variable Cost – – – – Fixed Cost 0 125 250 375 500 625 Volume (hours)

  11. Relevant Range... • is a band of volume in which a specific relationship exists between cost and volume. • Outside the relevant range, the cost may either increases or decreases. • A fixed cost is fixed only within a given relevant range and a given time period.

  12. Relevant Range $160,000 – $120,000 – $80,000 – $40,000 – – – Fixed Costs Relevant Range 0 5,000 10,000 15,000 20,000 25,000 Volume in Units

  13. Use a contribution margin statement of financial performance to make business decisions. Objective 2

  14. Two Approaches to Calculate Profits Conventional statement of financial performance Contribution margin statement of financial performance

  15. Conventional Statement Sales Cost of Goods Sold Gross Margin – = Net Profit Gross Margin Operating Expenses – =

  16. Contribution Margin Statement Sales Variable Expenses Contribution Margin – = Net Profit Contribution Margin Fixed Expenses – =

  17. Contribution Margin Example • Ly and Thu manufacture a device that allows users to download music from the internet more quickly. • The usual price for the device is $100. • Variable costs are $70. • They receive a proposal from a company in New Delhi to buy 20,000 units at a price of $85 each.

  18. Contribution Margin Example • There is sufficient capacity to produce the order. • How do we analyse this situation? • Selling price – variable cost = contribution margin • $85 – $70 = $15 contribution margin. • $15 × 20,000 units = $300,000 (total increase in contribution margin)

  19. Assumptions of CVP Analysis • Expenses can be classified as either variable or fixed. • CVP relationships are linear over a wide range of production and sales. • Sales prices, unit variable cost, and total fixed expenses will not vary within the relevant range.

  20. Assumptions of CVP Analysis • Volume is the only cost driver. • The relevant range of volume is specified. • Inventory levels will be unchanged. • The sales mix remains unchanged during the period.

  21. Calculate breakeven sales Objective 3

  22. Cost-Volume-Profit Analysis — Sales — Fixed — Fixed + Variable

  23. Cost-Volume-Profit Analysis • Accountants use two methods to perform CVP analysis. • Both methods use an equation or formula derived from the contribution margin statement of financial performance. Sx – Vx – F = 0

  24. Equation Approach With the equation approach, breakeven sales in units is calculated as follows: Unit sales price × Units sold – Variable unit cost × Units sold – Fixed expenses = Net Profit

  25. Breakeven Point Example • Assume that fixed expenses amount to $90,000. • How many devices must be sold at the regular price of $100 to break even? • ($100 × Units sold) – ($70 × Units sold) – $90,000 = 0 • Units sold = $90,000 ÷ $30 = 3,000

  26. Contribution Margin Per Unit Percent Ratio Sales price $100 100 1.00 Variable expenses 70 70 .70 Contribution margin $ 30 30 .30

  27. Contribution Margin Formula (Fixed expenses + Profit) ÷ Contribution margin per unit = Units ($90,000 + 0) ÷ $30 = 3,000 Units

  28. Contribution Margin Ratio Formula (Fixed expenses + Profit) ÷ Contribution margin ratio = $ Sales ($90,000 + 0) ÷ .30 = $300,000

  29. Change in Sales Price Example • Suppose that the sales price per device is $106 rather than $100. • What is the revised breakeven sales in units? • New contribution margin: $106 – $70 = $36 • $90,000 ÷ $36 = 2,500 units • $106 x 2,500 = $265,000 Sales

  30. Change in Variable Costs Example • Suppose that variable expenses per device are $75 instead of $70. • Other factors remain unchanged. • $90,000 ÷ $25 = 3,600 • $90,000 ÷ 0.25 = $360,000 • (or $100 x 3,600 = $360,000 Sales)

  31. Change in Fixed Costs Example • Suppose that rental costs increased by $30,000. • What are the new fixed costs? • $90,000 + $30,000 = $120,000 • What is the new breakeven point? • $120,000 ÷ $30 = 4,000 units

  32. Calculate the sales level needed to earn a target net profit. Objective 4

  33. Target Profit Example • Suppose that a business would be content with a $45,000 profit. • Assuming $100 per unit selling price, variable expenses of $70 per unit, and fixed expenses of $90,000, how many units must be sold? • ($90,000 + $45,000) ÷ $30 = 4,500

  34. Graph a set of cost-volume-profit relationships. Objective 5

  35. Various Sales Levels Example • A new example • (compare to Kay Parker page 961-70 text) • Assume selling price is $35 per unit. • Variable expense is $21 per unit. • Fixed cost is $7,000. • What is the breakeven point? • 500 units or $17,500 Sales • [$7,000 / ($35 - $21) = 500 units]

  36. Cost-Volume-Profit Graph Breakeven sales point 500 units or $17,500 Sales revenue line Total expense line Fixed expense line

  37. Various Sales Levels Example • What profit is expected when sales are 300 units? • (Contribution margin x Units sold) • $14 × 300 = $4,200 total contribution • Total contribution – fixed costs = profit $4,200 – $7,000 = ($2,800)

  38. Various Sales Levels Example • What profit is expected when sales are 1,000 units? • $14 × 1,000 = $14,000 $14,000 – $7,000 = $7,000

  39. Calculate a margin of safety. Objective 6

  40. Margin of Safety Example • Margin of safety is the excess of expected sales over breakeven sales. • Returning to Ly and Thu’s (the previous internet music example) assume breakeven point is 3,000 devices. • Suppose they expect to sell 4,000 during the period. • What is the margin of safety?

  41. Margin of Safety Example 4,000 – 3,000 = 1,000 units 1,000 × $100 = $100,000 1,000 × 4,000 = 25% $100,000 × $400,000 = 25%

  42. Use the sales mix in CVP analysis. Objective 7

  43. Sales Mix Example • Suppose that Ly and Thu plan to sell two types of devices instead of one. • They estimate that sales will be 3,000 regular devices and 1,000 large devices. • This is a 3:1 sales mix. • They expect 3/4 of the devices sold to be regular devices and 1/4 to be large devices.

  44. Sales Mix Example RegularLarge Sales price $100 $154 Variable expenses 70 100 Contribution margin 30 54 Sales mix (units) 3 1 $ 90 $ 54 The total is $144.

  45. Sales Mix Example Weighted-average contribution margin $144 ÷ (3 + 1) = $36 Breakeven sales $90,000 ÷ $36 = 2,500 2,500 × 3/4 = 1,875 regular devices 2,500 × 1/4 = 625 large devices

  46. Sales Mix Example 1,875 regular × $100 = $187,500 625 large × $154 = 96,250 Breakeven $283,750 $90,000 ÷ $144 = 625 packages in the mix

  47. Calculate profit using variable costing and absorption costing. Objective 8

  48. Product Costing Absorption costing assigns all manufacturing costs to products. Financial statements prepared under GAAP use absorption costing. Variable costing assigns only variable manufacturing costs to products. Variable costing is for internal use only.

  49. Product Costing Example Sportade has the following costs: Direct material unit cost $6.00 Direct labour unit cost $3.00 Variable manufacturing overhead $2.00 Variable marketing $2.50 Fixed manufacturing overhead per unit $5.00 What is the product cost per unit?

  50. Product Costing Example Absorption Costing Direct materials $ 6.00 Direct labour 3.00 Variable manufacturing overhead 2.00 Fixed manufacturing overhead 5.00 Total $16.00

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