Chapter 5 CVP

Managerial Accounting: Cost Behavior and Profit Analysis
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Managerial Accounting
Support decisions in the organization Cost and Profit Cost allocation Pricing Planning and budgeting
Cost Measurement
Accounting versus Economic costs Costs per service Per member per month Program costs, Departmental costs Capital Costs Organization related (direct and indirect) Volume related (fixed and variable)
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Direct Costs
Relationship to sub-unit being analyzed and volume of services provided If the service department closed, these costs would disappear.
Indirect Costs
Use of shared resources Space, information systems, utilities, housekeeping, maintenance, medical records, and general administration Also called overhead costs. If service department closed, the costs still remain.
Fixed Versus Variable Costs

Variable costs are related to activity, utilization, or volume. Fixed costs are predetermined.
short-term staffing, equipment, facilities and information systems. Over time even fixed costs will change.
Contractual obligations
Total Costs
Fixed plus Variable Average cost = Total cost/unit of activity As activity increases, average cost declines as fixed costs are spread out over more activity units.
Table 5.1 Cost behavior Illustration: Fixed and Variable Costs Variable Cost per Test Fixed Costs Per Year Laboratory Supplies $10 Labor Other fixed Costs $100,000 50,000 $150,000
Volume 0 1 50 100 500 1,000 5,000 10,000 15,000 20,000
Fixed Costs $150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000
Total Variable Costs $0 10 500 1,000 5,000 10,000 50,000 100,000 150,000 200,000
Total Costs $150,000 150,010 150,500 151,000 155,000 160,000 200,000 250,000 300,000 350,000
Average Cost Per Test ---150,010.00 3,010.00 1,510.00 310.00 160.00 40.00 25.00 20.00 17.50
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Cost Behavior Graph 5.1
Costs $
Total Costs
150,000 Fixed Costs
Total Variable Costs
0 Volume
Cost Behavior Illustration: Fixed Semi-fixed, and Variable Costs 5.2

Variable Cost per Test Laboratory Supplies Fixed Costs per Test $10 Labor Other fixed Costs Semi -Fixed Costs $100,000 Increase in Labor costs 50,000 above 15,000 tests $150,000 Total Fixed Costs 150,000 $ 150,000 150,000 185,000 185,000 Total Variable Costs 100,000 $ 140,000 150,000 160,000 200,000 $35,000
Volume 10,000 $ 14,000 15,000 16,000 20,000
Fixed Costs 150,000 150,000 150,000 150,000 150,000
Semi-Fixed Costs $0 $ 0 0 35,000 35,000
Total Costs 250,000 290,000 300,000 345,000 385,000
Average Cost Per Test $ 25.00 20.71 20.00 21.56 19.25
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Cost Behavior Graph 5.2

Total Costs
Costs $
Total Variable Costs

150,000 Fixed Costs Total Variable Costs
10,0000
15,000
Volume
(Number of Tests)
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Cost behavior model

Total costs depend on volume Revenues depend on volume Hence, we can examine the behavior of profit as revenues and costs change with volume.
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Cost-Volume-Profit Analysis
Important to determine profits for capital projects, determine pricing and service decisions, determine future management responses to change adverse situations
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Pro-Forma Profit and Loss Statement

Projection of profit (net income) given initial base case assumptions can be done with a CVP analysis. This is a forecast. Profit is calculated on the basis of assumed expected volume, price, and costs.
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A Clinic: 2005 Base Case Pro-Forma P&L Statement Total Revenues ($100*75,000) Total variable costs ($28.18*75,000) Total contribution margin ($71.82*75,000) Fixed Costs Profit (net income)
$ $ $
7,500,000 2,113,500 5,386,500 4,967,462 419,038
1. Based on 75,000 patient visits 2. Breakeven point is 69,165 patient visits. Solve TR - $100xVisits = 0 TC - FC -28.18xVisits = 0
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Profit(CVP) Analysis
Cost-Volume-Profit Analysis Evaluate future courses of action Most be based on forecasts Inherent risk that the future will not conform to the forecast
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Atlanta Clinic: Forecasted Cost Data for 2005 (75,000 visits)

Variable Costs Salaries and Benefits: Management and supervision Coordinators Specialists Technicians Clerical/administrative Social security taxes Group Health insurance Professional fees Supplies Utilities Allocated costs Total 442,617.00 681,383.00 71,182.00 89,622.00 115,924.00 325,489.00 313,283.00 74,000.00 2,113,500.00 Fixed Costs 928,687 598063 38600 552670 58240 163188 211081 383360 231184 45040 1757349 4,967,462 Total Costs 928,687.00 1,040,680.00 38,600.00 1,234,053.00 129,422.00 252,810.00 327,005.00 708,849.00 544,467.00 119,040.00 1,757,349.00 7,080,962.00
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Cost Behavior Model

Total cost = Fixed Costs + Total variable costs = $4,967,462 +($28.18 x Number of visits)
$2,113,500/75,000 = $28.18 per visit
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Using the Equation

Volume = 70,000:
TC = FC + VC TC=4,967,462+28.18 x 70,000 = $6,940,062
Volume = 75,000:
TC = 4,967,462+28.18*75,000 = $7,080,962
Volume = 80,000
TC = 4,967,462 +$28.18 x 80,000 = $7,221,862
Atlanta Clinic CVP Graphical Model

10,000,000 9,000,000 8,000,000 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 -
25000
45000
55000
65000
75000
85000
95000
Fixed cost Total Revenue Total cost
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Atlantic Clinic: CVP Graphical Model Volume 0 25,000.00 45,000.00 55,000.00 65,000.00 75,000.00 85,000.00 95,000.00 Fixed Cost Variable Cost Total Cost Total Revenue 4,967,462 0 4,967,462 0 4,967,462 704500 5,671,962 2500000 4,967,462 1268100 6,235,562 4500000 4,967,462 1549900 6,517,362 5500000 4,967,462 1831700 6,799,162 6500000 4,967,462 2113500 7,080,962 7500000 4,967,462 2395300 7,362,762 8500000 4,967,462 2677100 7,644,562 9500000 Profit (4,967,462) (3,171,962) (1,735,562) (1,017,362) (299,162) 419,038 1,137,238 1,855,438
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Atlanta Clinic: 2005 Base Case Pro-Forma P&L Statement

( Based on 75,000 patient visits) Total Revenues ($100 x 75,000) Total variable costs ($28.18 x 75,000) Total contribution margin ($71.82 x 75,000) Fixed costs Profits (net income) contribution rate is (100 - 28.81) 7,500,000 2,113,500 5,386,500 4,967,462 419,038
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Contribution Margin
Unit revenue - per unit variable cost Does not include fixed costs After fixed costs are covered, there will be a profit.
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Breakeven Analysis
Total Revenues - Total Variable Costs - Fixed Costs = Profit ($100*volume) - (28.18 * volume) - $4,967,462 = Profit At breakeven, set profit equal to 0 Solve for volume 69,165 visits Volume greater produces profit Volume lower produces loss Profit for Visits above the breakeven volume can be calculate by multiplying the contributing margin times incremental volume above the breakeven volume.
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Atlanta Clinic: 2005 Base Case Pro-Forma P%L Statement ( Based on 69,165 patient visits) Total Revenues ($100 x 69,165) Total variable costs ($28.18 x 69,165) Total contribution margin ($71.82 x 69,165) Fixed costs Profits (net income) contribution rate is (100 - 28.81) $ 6,916,500 1,949,070 4,967,430 4,967,462 (32)
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Table 5.6 Atlanta Clinic: 2005 Projected Pro-Forma P&L Statement 69,165 6,916,500 1,949,070 4,967,430 4,967,462 (32) Number of Visits 75,000 $ 7,500,000 $ 2,113,500 $ 5,386,500 $ 4,967,462 $ 419,038 $ 82,500 8,250,000 2,324,850 5,925,150 4,967,462 957,688
Total Revenues ($100 x volume) Total variable costs ($28.18 x volume) Total contribution margin ($71.82 x volume) Fixed costs Profits (net income)
$ $ $
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Operating Leverage
A health care provider that has a higher proportion of fixed costs and a lower proportion of variable costs has more operating leverage. A provider with lower fixed costs and higher variable costs has less operating leverage The higher the degree of operating leverage, the greater the potential danger from volume variation If a relatively small error is made in forecasting utilization, there would be large errors in cash flow projections.
Operating Leverage
High proportion of total costs are fixed Small change in volume leads to large change in profit Firms with a high degree of operating leverage often have economies of scale. But have high breakeven points, which increases risk of losses. Hospitals are the usual example of such a firm.
Degree of Operating Leverage

The degree of operating leverage (DOL), is defined as the percentage change in operating income (or EBIT) that results from a given percentage change in sales The DOL is an index number which measures the effect of a change in utilization on operating income, or EBIT. DOL = (EBIT2-EBIT1)/EBIT1 (Q2-Q1)/Q1
Calculating DOL
Change in EBI ($957,688 -$419,038)/419,038 = $538,650/$419,038 = 1.285 (128.5%) Change in Utilization (82,500-75,000)/75,000 = 7,500/75,000 = .1000 (10.00%) 128.5%/10% = 12.85
Calculating DOL
Gapenski also uses the following calculation in book and in problem set:
Total Contributing Margin / EBIT $5,386,500 / $419,038 = 12.85 Same answer as previous slide.
CVP Analysis in a Discounted Fee-for-Service Environment

25,000 visits come from Peachtree HMO 40 percent discount requested
$60 per patient
Full cost is $94.41 per visit Lose (94.41-60)=$34.41 per patient Total loss ($34.41 x 25,000)=$860,250 Reject?
Impact of rejecting proposal

Going to lose market share of 25,000 Still have large fixed costs. Will not break even.
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Table 5.7 Atlanta Clinic: 2005 Base Case Pro-Forma P&L Statement ( Based on 50,000 undiscounted patient visits) Volume = 50,000 Total Revenues ($100 x volume) Total variable costs ($28.18 x volume) Total contribution margin ($71.82 x volume) Fixed costs Profits (net income) Would lose 25,000 patient visists $ 5,000,000 1,409,000 3,591,000 4,967,462 (1,376,462)
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Impact of Accepting the Proposal

Two revenue streams must be studied Undiscounted revenue Discounted revenue What happens to bottom line?
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Table 5.8 Atlanta Clinic: 2005 Base Case Pro-Forma P&L Statement ( Based on 50,000 undiscounted patient visits) Volume = 75,000 Undiscounted Revenue($100 x 50,000) Discounted revenue ($60 x 25,000) Total revenues ($86.67 x 75,000) Total variable costs ($28.18 x volume) Total contribution margin ($58.49 x volume) Fixed costs Profits (net income) $ $ $ $ 5,000,000 1,500,000 6,500,000 2,113,500 4,386,500 4,967,462 (580,962)
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Profit Analysis Atlantic Clinic

Losing ($580,962) is better than losing ($1,376,462) Fixed costs are not reduced in the short run so taking the Peachtree contract is sensible. However, Atlanta clinic cannot continue running a deficit. I revenues not restored, than cost cutting will be done to lower fixed costs.
Atlanta Clinic CVP Graphical Model

10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 45 ,0 00 .0 0 65 ,0 00 .0 0 85 ,0 00 .0 0 0
Fixed cost Total Revenue Total cost Peachtree
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Breakeven Point under Acceptance

The average revenue per visit is $86.67
2/3*$100+1/3*$60
New Breakeven is 84,928 visits $4,967,462/$(86.67-28.18) $4,967,462/58.49 Use new lower contribution margin
Evaluating the Alternatives

Not Accept
Loss will be ($1,376,462)
Accept
Loss will be ($580,962)
Can you make a counteroffer? It will all depend on market conditions. Your best strategy may be to accept. Gain $795,500 in the short run.
Marginal Analysis: Short-Term Versus Long-Term Implications

Now suppose the Atlanta clinic forecasted only a volume of 50,000 Peachtree offer 25,000 at $60 per visits Should you accept? Yes, each visit adds a positive $31.82 to recovering those pesky fixed costs. Will others exit? Become more dominant Will other payer's demand discount? Lose revenue in next round.
CVP in a Capitated Environment

Get Upfront payment of $7,500,000 Now has insurance function for a covered population. Controlling utilization is the key.
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Atlantic Clinic: CVP Graphical Model Capitation Volume 0 25000 45000 55000 65000 75000 85000 95000 105000 115,000 Fixed Cost Variable Cost Total Cost Total Revenue 4,967,462 0 4,967,462 7500000 4,967,462 704500 5,671,962 7500000 4,967,462 1268100 6,235,562 7500000 4,967,462 1549900 6,517,362 7500000 4,967,462 1831700 6,799,162 7500000 4,967,462 2113500 7,080,962 7500000 4,967,462 2395300 7,362,762 7500000 4,967,462 2677100 7,644,562 7500000 4,967,462 2958900 7,926,362 7500000 4,967,462 3240700 8,208,162 7500000 Profit 2,532,538 1,828,038 1,264,438 982,638 700,838 419,038 137,238 (144,562) (426,362) (708,162)
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Atlanta Clinic CVP Capitation

10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 45 00 0 65 00 0 85 00 0 10 50 00 0
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Under Capitation
Profits increase with fewer visits Utilization constraints are profitable Criticisms exist of the incentives in capitation contracts.
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Members and Capitation

Volume is now interpreted as members Revenue line is rising by $400 per member annually Member are good as long as utilization is controlled. Per visit cost reductions are good for the bottom line
Atlanta Clinic: Breakeven Point Under Capitation in Insurance Terms
15,000,000 12,500,000 10,000,000 7,500,000 5,000,000 2,500,000 -
2, 50 5, 0 1 0 0 00 ,0 12 00 , 15 500 ,0 17 00 , 20 250 ,0 22 00 , 25 500 ,0 00

Members
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Capitation and Insurance

Revenue is $400 per year
($33.33 PMPM)
Variable cost per member is 4 x $28.18 =112.72

Based on 4 visits of utilization per member
Note utilization is good under fee-for-service Under capitation, control both utilization and cost per visit Always want to control overhead.
Capitated Pro-Forma P&L Statements

Statement shows profit declining when volume increases Contribution margin becomes a $28.18 because no revenue contribution
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Atlanta Clinic: 2005 Pro-Forma P&L Statement Under Capitation

Total Revenues Total variable costs ($28.18 x volume) Total contribution margin Fixed costs Profits (net income) $ $ $ 69,165 7,500,000 1,949,070 5,550,930 4,967,462 583,468 Number of Visits 75,000 $ 7,500,000 $ 2,113,500 $ 5,386,500 $ 4,967,462 $ 419,038 $ 82,500 7,500,000 2,324,850 5,175,150 4,967,462 207,688
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Breakeven Point Under Capitation

Total Revenues Total Variable Costs Fixed Costs = Profit
$7,500,000 - (28.18 x volume) - $4967,462 = $0
$28.18*volume = $2,532,538 volume = 89,870 Below this volume in visits results in a profit and above results in a loss.
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The higher the proportion of fixed costs the higher the operating leverage
In fee-for- service, small cut in volume leads to large cut in bottom line profitability
A higher fixed cost structure leads to larger decreases in profitability and more risk.
In capitation, small cut in volume leads to small increase in profitability.

A higher fixed cost structure leads to reduced risk
Number of Members and Breakeven Analysis

Assume 4 visits per member Variable cost is $112.72 per member
$28.18 x 4
TR TVC FC = Profit
(400xMembers) ($112.72xMembers) - $4,967,462 = $0
$287.28 x Members = $4,967,462 Members = 17,291

Utilization and Breakeven Analysis

If utilization increases from 4 to 4.4, variable cost pre member increases to 4.4x28.18=123.99. Breakeven point is now at 17,997 If utilization decreases to 3.69, variable cost per member declines to 3.96 x 28.18 = 103.98. Breakeven point is now at 16,781.
Atlanta Clinic: 2005 Pro-Forma P&L Statement for Members

Total Revenues ($400 x Members) Total variable costs ($112.72 x volume) Total contribution margin Fixed costs Profits (net income) TVC = TR = $ 112.72 $ 400.00 $ $ $ 17,291 6,916,400 1,949,042 4,967,358 4,967,462 (104) Number of Members 18,750 20,625 $ 7,500,000 $ 8,250,000 2,113,500 2,324,850 $ 5,386,500 $ 5,925,150 4,967,462 4,967,462 $ 419,038 $ 957,688
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Operating Leverage and Members

A 10 percent increase in members from 18,750 to 20,625 results in 128.5% increase in profits
[(957,688-419,038)/419,038] = 128.5%
A decline of membership to 17,291 (the breakeven point), results in a decrease of profit of 100%
[(419038-(-104)/419,038] = 100.0%

Chapter 5 CVP

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Managerial Accounting: Cost Behavior and Profit Analysis

Cartwright Financial Management

Cartwright Financial Management

Cartwright Financial Management

Fixed Versus Variable Costs

Cartwright Financial Management

Volume 0 1 50 100 500 1,000 5,000 10,000 15,000 20,000

Cartwright Financial Management

Cost Behavior Graph 5.1

150,000 Fixed Costs

Total Variable Costs

Cartwright Financial Management

Cost Behavior Illustration: Fixed Semi-fixed, and Variable Costs 5.2

Volume 10,000 $ 14,000 15,000 16,000 20,000

Fixed Costs 150,000 150,000 150,000 150,000 150,000

Semi-Fixed Costs $0 $ 0 0 35,000 35,000

Total Costs 250,000 290,000 300,000 345,000 385,000

Average Cost Per Test $ 25.00 20.71 20.00 21.56 19.25

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Cost Behavior Graph 5.2

Total Variable Costs

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Cost behavior model

Cartwright Financial Management

Cartwright Financial Management

Pro-Forma Profit and Loss Statement

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7,500,000 2,113,500 5,386,500 4,967,462 419,038

Cartwright Financial Management

Cartwright Financial Management

Atlanta Clinic: Forecasted Cost Data for 2005 (75,000 visits)

Cartwright Financial Management

Cost Behavior Model

Cartwright Financial Management

Using the Equation

Atlanta Clinic CVP Graphical Model

Cartwright Financial Management

Fixed cost Total Revenue Total cost

Cartwright Financial Management

Atlanta Clinic: 2005 Base Case Pro-Forma P&L Statement

Cartwright Financial Management

Cartwright Financial Management

Cartwright Financial Management

Cartwright Financial Management

Cartwright Financial Management

Degree of Operating Leverage

CVP Analysis in a Discounted Fee-for-Service Environment

Impact of rejecting proposal

Cartwright Financial Management

Cartwright Financial Management

Impact of Accepting the Proposal

Cartwright Financial Management

Cartwright Financial Management

Profit Analysis Atlantic Clinic

Atlanta Clinic CVP Graphical Model

Fixed cost Total Revenue Total cost Peachtree

Cartwright Financial Management

Breakeven Point under Acceptance

Evaluating the Alternatives

Marginal Analysis: Short-Term Versus Long-Term Implications

CVP in a Capitated Environment

Cartwright Financial Management