TM 6-1

CVP ANALYSIS Cost-volume-profit (CVP) analysis is concerned with the effects on net operating income of ! "elling prices# ! "ales volume# ! $nit varia%le costs# ! Total fi&ed costs# ! The mi& of products sold# AGENDA 1# 'eview of contri%ution income statement# (# )ffects of changes in sales volume on net operating income# *# CVP graph# +# Contri%ution margin (CM) ratio# ,# -rea.-even analysis# 6# Target profit analysis# /# Margin of safety# 0# 1perating leverage#

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TM 6-( THE CONTRIBUTION APPROACH 2 contri%ution format income statement is very useful in CVP analysis since it highlights cost %ehavior# )32MP4) 4ast month5s contri%ution income statement for 6ord Corporation7 a manufacturer of e&ercise %icycles7 follows Total 8(,97999 1,97999 1997999 097999 8 (97999 Per Unit 8,99 *99 8(99 Percen t 199: 69 +9:

"ales (500 bikes)############ 4ess varia%le e&penses# # Contri%ution margin####### 4ess fi&ed e&penses####### 6et operating income##### CONTRIBUTION MARGIN:

! The amount that sales (net of varia%le e&penses) contri%utes toward covering fi&ed e&penses and then toward profits# ! The unit contri%ution margin remains constant so long as the selling price and the unit varia%le cost do not change#

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TM 6-* VOLUME CHANGES AND NET OPERATING INCOME Contri%ution income statements are given on this and the following page for monthly sales of 17 (7 +997 and +91 %i.es# Total "ales (1 bike)######################## 4ess varia%le e&penses######### Contri%ution margin############### 4ess fi&ed e&penses############## 6et operating income (loss)# # 8 ,99 *99 (99 097999 8(/;7099) Total "ales (2 bikes)####################### 4ess varia%le e&penses######### Contri%ution margin############### 4ess fi&ed e&penses############## 6et operating income (loss)# # 6ote the following points 1# (# The contri%ution margin must first cover the fi&ed e&penses# <f it doesn5t7 there is a loss# 2s additional units are sold7 fi&ed e&penses are whittled down until they have all %een covered# 8 17999 699 +99 097999 8(/;7699) Per Unit 8,99 *99 8(99 Percen t 199: 69 +9:

Per Unit 8,99 *99 8(99

Percen t 199: 69 +9:

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TM 6-+ VOLUME CHANGES AND NET OPERATING INCOME (contd) Total "ales (400 bikes)##################### 4ess varia%le e&penses########### Contri%ution margin################# 4ess fi&ed e&penses################ 6et operating income (loss)##### 8(997999 1(97999 097999 097999 8 9 Total "ales (401 bikes)##################### 4ess varia%le e&penses########### Contri%ution margin################# 4ess fi&ed e&penses################ 6et operating income (loss)##### 6ote the following points 1# (# <f the company sells e&actly +99 %i.es a month7 it will =ust %rea. even (no profit or loss)# The %rea.-even point is ! The point where total sales revenue e>uals total e&penses (varia%le and fi&ed)# ! The point where total contri%ution margin e>uals total fi&ed e&penses# *# )ach additional unit sold increases net operating income %y the amount of the unit contri%ution margin# 8(997,99 1(97*99 097(99 097999 8 (99 Per Unit 8,99 *99 8(99 Percen t 199: 69 +9:

Per Unit 8,99 *99 8(99

Percen t 199: 69 +9:

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TM 6-, PREPARING A CVP GRAPH

$300
Step 3 (Total Sales) Step 2 (Total Expenses)

Dollars (000)

250 230 $200

$100 80

Step 1 (Fixed Expenses)

200 400 Number of bikes

500

600

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TM 6-6 THE COMPLETED CVP GRAPH

$300

T o ta l S a le s
ar it f o Pr ea

D o lla r s (0 0 0 )

B r e a k -e v e n p o in t: 4 0 0 b ik e s o r $ 2 0 0 ,0 0 0 in s a le s $200

T o ta l Expenses

$100 80

s Lo

ar

ea

200

400 N u m b e r o f b ik e s

600

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TM 6-/ CONTRIBUTION MARGIN RATIO The contri%ution margin (CM) ratio is the ratio of contri%ution margin to total sales CM ratio? Contri%ution margin Total sales

<f the company has only one product7 the CM ratio can also %e computed using per unit data CM ratio? $nit contri%ution margin $nit selling price

)32MP4) @or 6ord Corporation7 the CM ratio is +9:7 computed as follows CM ratio? Contri%ution margin 81997999 ? ? +9: Total sales 8(,97999 or CM ratio? $nit contri%ution margin 8(99 per unit ? ? +9: $nit selling price 8,99 per unit

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TM 6-0 CONTRIBUTION MARGIN RATIO (contd) The CM ratio shows how the contri%ution margin will %e affected %y a given change in total sales# )32MP4) 2ssume that 6ord Corporation5s sales increase %y 81,97999 ne&t month# Ahat will %e the effect on (1) the contri%ution margin and (() net operating incomeB (1))ffect on contri%ution margin <ncrease in sales######################### Multiply %y the CM ratio############### <ncrease in contri%ution margin### (())ffect on net operating income <f fi&ed e&penses do not change7 the net operating income for the month will also increase %y 8697999# "ales (in units)################# "ales (in dollars)############## 4ess varia%le e&penses### Contri%ution margin######### 4ess fi&ed e&penses######## 6et operating income###### Present Expected ,99 099 8(,97999 8+997999 1,97999 (+97999 1997999 1697999 097999 097999 8 (97999 8 097999 Change *99 81,97999 ;97999 697999 9 8 697999 81,97999 C +9: 8 697999

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TM 6-; BREAK-EVEN ANALYSIS Summar o! "ord Corporation #ata$ Per %ike Percen t "elling price########################### 8,99 199: Varia%le e&penses################# *99 69 Contri%ution margin############### 8(99 +9: @i&ed e&penses##################### E UATION METHOD D ? -rea.-even >uantity in %i.es Profits ? "ales E (Varia%le e&penses F @i&ed e&penses) "ales ? Varia%le e&penses F @i&ed e&penses F Profits 8,99D ? 8*99D F 8097999 F 89 8(99D ? 8097999 D ? 8097999 G 8(99 per %i.e D ? +99 %i.es 3 ? -rea.-even point in sales dollars "ales ? Varia%le e&penses F @i&ed e&penses F Profits 3 ? 9#693 F 8097999 F 89 9#+93 ? 8097999 3 ? 8097999 G 9#+9 3 ? 8(997999 CONTRIBUTION MARGIN METHOD @i&ed e&penses 8097999 -rea.even ? ? ? +99 %i.es in units $nit contri%ution margin 8(99 per %i.e -rea.even ? @i&ed e&penses ? 8097999 ? 8(997999 in sales dollars CM ratio 9#+9 Per &onth

8097999

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TM 6-19 TARGET PRO!IT ANALYSIS )32MP4) 2ssume that 6ord Corporation5s target profit is 8/97999 per month# How many e&ercise %i.es must it sell each month to reach this goalB E UATION METHOD D ? 6um%er of %i.es to attain the target profit "ales ? Varia%le )&penses F @i&ed )&penses F Profits 8,99D ? 8*99D F 8097999 F 8/97999 8(99D ? 81,97999 D ? 81,97999 G 8(99 %i.es D ? /,9 -i.es (or7 in sales dollars7 /,9 %i.es C 8,99 per %i.e ? 8*/,7999) 3 ? Iollar sales to reach the target profit figure "ales ? Varia%le )&penses F @i&ed )&penses F Profits 3 ? 9#693 F 8097999 F 8/97999 9#+93 ? 81,97999 3 ? 81,97999 G 9#+9 3 ? 8*/,7999 CONTRIBUTION MARGIN METHOD $nit sales to attain ? @i&ed e&penses F Target profit target profit $nit contri%ution margin ? 809799F 8/97999 ? /,9 %i.es 8(99 per %i.e

Iollar sales to attain ? @i&ed e&penses F Target profit target profit CM ratio ? 809799F 8/97999 ? 8*/,7999 9#+9

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TM 6-11 MARGIN O! SA!ETY The margin of safety is the e&cess of %udgeted (or actual) sales over the %rea.-even sales# The margin of safety can %e e&pressed either in dollar or percentage form# The formulas are Margin of safety ? Total sales--rea.even sales in dollars Margin of safety ? Margin of safety in dollars percentage Total sales Compan ' 8,997999 199: *,97999 /9 1,97999 *9: ;97999 8 697999 8*997999 8+(,7999 8(997999 8/,7999 +9: 1,: Compan ( 8,997999 199: 1997999 (9 +997999 09: *+97999 8 697999

"ales#################################### 4ess varia%le e&penses######## Contri%ution margin############## 4ess fi&ed e&penses############# 6et operating income########### -rea.-even point 8;97999 G 9#*9################### 8*+97999 G 9#09################# Margin of safety in dollars 8,997999 E 8*997999######### 8,997999 E 8+(,7999######### Margin of safety percentage 8(997999 G 8,997999######### 8/,7999 G 8,997999###########

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TM 6-1( OPERATING LEVERAGE 1perating leverage measures how a given percentage change in sales affects net operating income# Contri%ution margin Iegree of ? operating leverage 6et operating income "ales####################################### 4ess varia%le e&penses########## Contri%ution margin################ 4ess fi&ed e&penses############### 6et operating income############## Iegree of operating leverage# Compan ' 8,997999 199: *,97999 /9 1,97999 *9: ;97999 8 697999 (#, Compan ( 8,997999 199: 1997999 (9 +997999 09: *+97999 8 697999 6#/

<f the degree of operating leverage is (#,7 then a 19: increase in sales should result in a (,: (? (#, C 19:) increase in net operating income# )32MP4) 2ssume that %oth company 3 and company J e&perience a 19: increase in sales "ales########################################### 4ess varia%le e&penses############### Contri%ution margin##################### 4ess fi&ed e&penses#################### 6et operating income################## <ncrease in net operating income Compan ' 8,,97999 199: *0,7999 /9 16,7999 *9: ;97999 8 /,7999 (,: Compan ( 8,,97999 199: 1197999 (9 ++97999 09: *+97999 81997999 6/:

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TM 6-1* OPERATING LEVERAGE (contd) The degree of operating leverage is not constantKit changes with the level of sales# )32MP4) 2t the higher level of sales7 the degree of operating leverage for Company 3 decreases from (#, to (#( and for Company J from 6#/ to +#+# Compan ' )000s* 8,99 8,,9 *,9 *0, 1,9 16, ;9 ;9 8 69 8 /, (#, (#( Compan ( )000s* 8,99 8,,9 199 119 +99 ++9 *+9 *+9 8 69 8199 6#/ +#+

"ales########################################## 4ess varia%le e&penses############## Contri%ution margin#################### 4ess fi&ed e&penses################### 6et operating income################# Iegree of operating leverage#####

1rdinarily7 the degree of operating leverage declines as sales increase#

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TM 6-1+

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TM 6-16 MA"OR ASSUMPTIONS O! CVP ANALYSIS 1# (# "elling price is constant# The price does not change as volume changes# Costs are linear and can %e accurately split into fi&ed and varia%le elements# The total fi&ed cost is constant and the varia%le cost per unit is constant# The sales mi& is constant in multi-product companies# <n manufacturing companies7 inventories do not change# The num%er of units produced e>uals the num%er of units sold#

*# +#

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