CHAPTER 5 Notes Cost-Volume-Profit (CVP) Relationships

Certain materials used #ith permission of $%&ra#-Hill Companies' (n%)

Compiled by !ennifer Rottin"haus

*nderstandin" +hy CVP Analysis (s (mportant

Useful for planning and making operating decisions. Helpful in analyzing how operating income (profits) may vary in relation to changes in several key variables: sales pri%e' sales ,olume' ,ariable %osts' fi-ed %osts' mi- of produ%ts sold) Allows managers to answer some very important uestions:

The .asi%s of CVP Analysis

Contribution (n%ome /tatement
(introduced in !hapter ") Useful as a planning tool# management can pro$ect profits at any level of activity within the relevant range %ay be reflected in total dollars& per unit& or as a ratio (')

ACCT 211 Chapter 5 Summer 2013 Student Version

Page 2 of 14

E0A$P1E (ast month)s contribution income statement for *mith and !ompany& a bicycle manufacturer& follows: Total Sales (500 bicycles $ess %aria&le e'penses Contribution margin $ess fi'ed e'penses *et operating in+ome !250"000 150"000 100,000 )0"000 ! 20"000 Per Unit !500 300 $200 Percent 100# (0 40%

Contribution $ar"in (C$)

Sales,Varia&le Costs- Contri&ution margin

+ifference between sales revenues and variable costs. ,ortion of sale revenue left over after the variable costs have been paid. !ontribution margin is used to %o,er the fi-ed %osts of the business. -nce all fi.ed costs have been covered& any contribution margin left over represents operatin" in%ome (profit)) %any operating decisions made on basis of !ontribution %argin. /0A%,(/: A company may decide to advertise one product more than another because it has a hi"her contribution margin.

Per-*nit Contribution $ar"in

Sales pri+e per unit,%aria&le +ost per unit- Contri&ution margin per unit.

Amount from each unit of sales available to cover fi.ed cost and provide a profit

ACCT 211 Chapter 5 Summer 2013 Student Version

Page 3 of 14

Contribution $ar"in Ratio

/nit +ontri&ution margin Sales pri+e per unit-u

Per%enta"e of net sales revenue left after variable costs are deducted. Used to compare the profitability of various products# emphasize product(s) with the hi"hest ratio) Helps managers answer uestions such as: +hat is the impa%t on ,ariable %osts' %ontribution mar"in' and profit if #e in%rease sales by 023 Using ratios& /ales is al#ays 4552) *o& if we have the either the 1! ratio or the !% ratio& we can solve for the other.

(n-Class E-er%ises
(") 2anner !reations has sales of 345&555& fi.ed costs of 675&555& and variable costs of 6895&555. :hat is the total contribution margin and the contribution margin ratio;

(<)

=f the contribution margin ratio for %anville /nterprises is 8<'& sales were 64>5&555& and fi.ed costs were 6"75&555& what was the income from operations;

ACCT 211 Chapter 5 Summer 2013 Student Version

Page 4 of 14

/ales Volume Chan"es and Net 6peratin" (n%ome (Profit) ?he following contribution income statements are for *mith and !ompany for monthly sales of "& <& 355& and 35" bicycles.
Sales (1 bicycle) $ess %aria&le e'penses Contri&ution margin $ess fi'ed e'penses *et operating in+ome (loss Sales (2 bicycles) $ess %aria&le e'penses Contri&ution margin $ess fi'ed e'penses *et operating in+ome (loss Sales (400 bicycles) $ess %aria&le e'penses Contri&ution margin $ess fi'ed e'penses *et operating in+ome (loss Sales (401 bicycles) $ess %aria&le e'penses Contri&ution margin $ess fi'ed e'penses *et operating in+ome (loss
@ote the following points: ". ?he contribution margin must first cover the fi.ed e.penses. =f it doesn)t& there is a loss. <. =f *mith sells e-a%tly 755 bi8es a month& he will $ust brea8-e,en) 8. /ach additional unit sold increases net operating income by the amount of the unit %ontribution mar"in.

Total Per Unit ! 500 !500 300 300 200 !200 )0"000 !(01")00 Total Per Unit ! 1"000 !500 (00 300 400 !200 )0"000 !(01"(00 Total Per Unit !200"000 !500 120"000 300 )0"000 !200 )0"000 ! 0 Total Per Unit !200"500 !500 120"300 300 )0"200 !200 )0"000 ! 200

Percent 100# (0 40#

Percent 100# (0 40#

Percent 100# (0 40#

Percent 100# (0 40#

ACCT 211 Chapter 5 Summer 2013 Student Version

Page 5 of 14

/imultaneous Chan"es in /e,eral (tems

-ften& a decision will affect more than $ust a change in sales volume. *everal items will change at the same time. /0A%,(/*: (see pages "74A<5") !hange in Bi.ed !ost and *ales 1olume !hange in 1ariable !osts and *ales 1olume !hange in Bi.ed !ost& *ales ,rice& and *ales 1olume !hange in 1ariable !ost& Bi.ed !ost& and *ales 1olume !hange in Cegular *ales ,rice ?o analyze multiple changes& each change must be incorporated in the !1, analysis.

(n%ome /tatement Approa%h ,ersus (n%remental Analysis

=ncome *tatement Approach D potential changes are incorporated in a separate contribution income statement and then compared with a contribution income statement prior to the changes. =ncremental Analysis D focuses only on those items that change. /ither method will result in the same solution. ?he incremental approach can sometimes be shorter& but = personally prefer the income statement approach because it gives us the Efull pictureF. 2oth methods are illustrated in the e.amples on page "74.

CVP Relationships in &raphi% 9orm

ACCT 211 Chapter 5 Summer 2013 Student Version

Page ( of 14

A "raphi% format may be the most effe%ti,e method to communicate information because it allows managers to ,isuali:e and e.amine cost and revenue data over a ran"e of a%ti,ity rather than at a sin"le ,olume. However& because it is diffi%ult to read pre%ise information from a "raph& management will typically use the mathemati%al approa%h to analy:e spe%ifi% proposals)

Preparin" a CVP &RAPH

Volume or a%ti,ity le,el (units of sales) is on the hori:ontal a-is) Total sales and %ost dollars are on the ,erti%al a-is. Graph consists of a fi-ed e-penses line& a total sales line' and a total e-penses line. ?he interse%tion of the total sales line and the total e-penses line is the brea8-e,en point) !1, Graph can be used to illustrate items such as: (") ?otal variable e.penses (<) ?otal fi.ed e.penses (8) Area of sales activity in which losses occur (3) Area of sales activity in which profits will be realized (>) 2reakAeven point

ACCT 211 Chapter 5 Summer 2013 Student Version

Page 0 of 14

$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

.rea8-E,en Analysis

ACCT 211 Chapter 5 Summer 2013 Student Version

Page ) of 14

.rea8-E,en Point
1olume of activity (level of operations) at which a company)s revenues and e.penses are e ual @o profit or loss AA simply: Re,enues ; E-penses or Contribution $ar"in ; 9i-ed Costs *o why is this so important; (t helps us determine ho# many units #e must sell in order to determine at #hat point #e start ma8in" profit)

T#o $ethods for %omputin" .rea8-E,en Point E<uation $ethod

/ uation:

At the breakAeven point& profits are :ero. *o& the breakAeven formula is:
(C2 per unit 3 %olume, fi'ed e'pense-0

?he rest is basic math# $ust insert the known components of the formula and then solve for the unknown component.

Contribution $ar"in $ethod

.rea8-e,en point in

(AHA Bormula %ethod)

4i'ed e'oenses5C2 per unit

ACCT 211 Chapter 5 Summer 2013 Student Version

Page 1 of 14

units sold

.rea8-e,en point in total sales dollars

4i'ed e'penses5C2 ratio

?o calculate .E /ales in *nits A use *nit Contribution $ar"in ?o calculate .E /ales in =ollars D use Contribution $ar"in Ratio (2)

Tar"et Profit Analysis

Tar"et profit is that level of profit management desires. ?o determine what level of sales volume is necessary to reach a target profit& we simply modify the breakeven formula.

E<uation $ethod
=nstead of solving for the sales where profits are zero& we set the profit e ual to the target profit:
(C2 per unit 3 %olume, fi'ed e'pense- target profit

Contribution $ar"in $ethod

Iust add the target profit in the numerator.

4i'ed e'penses6Taret profit5C2 per unit

ACCT 211 Chapter 5 Summer 2013 Student Version

Page 10 of 14

.rea8-e,en point in units sold ;

.rea8-e,en point in total sales dollars

4i'ed e'penses6Target profit5C2 ratio

*sin" CVP to Analy:e Cost /tru%tures

!ost *tructure is the proportion of fi.ed and variable costs to total costs. ?hese differ widely between industries and between organizations within the same industry. :hy is the cost structure so important: (t determines #hat #e need to sell to brea8-e,en 6peratin" le,era"e describes the e.tent to which a company)s cost structure is made up of fi-ed %osts. Bormula: C$@Net operatin" in%ome ?he higher the operating leverage& the higher a company)s fi.ed costs& the higher the R(/>?

ACCT 211 Chapter 5 Summer 2013 Student Version

Page 11 of 14

?he e.cess of sales over the breakAeven sales level is called the $ar"in of /afety. %anagers get the warm fuzzies when the margin of safety is a large numberJ ?his $ust tells managers that they have some cushion between the breakAeven point and their current situation. %argin of *afety formula:

%argin of *afety percentage:

CVP A $ultiple Produ%ts

ACCT 211 Chapter 5 Summer 2013 Student Version

Page 12 of 14

Up to this point& we)ve only looked at companies with a single product line. However& most companies have multiple product lines. ?o apply !1, modeling to multiple products we must first determine the product or sales mi.. /ales $i- refers to the proportion in which a company sells its products. @e.t& find the breakAeven point for the company as a whole.

@ow& we can allocate the breakAeven point among the different products using the sales mi..

(n-Class E-er%ises
E-er%ise 4 !ambridge !orporation had the following sales and cost data.

ACCT 211 Chapter 5 Summer 2013 Student Version

Page 13 of 14

Sales Volume Sales 7e%enue Varia&le 8'penses 4i'ed 8'penses !ompute the following: ". ?otal contribution margin:

20"000 units !(00"000 !310"000 !150"000

<. !ontribution margin ratio:

8. Unit contribution margin:

3. ?he increase in profit that will result from a 695&555 increase in sales price:

>. ?he increase in profit from a "&<55 increase in sales units:

E-er%ise B (%@ !orporation produces a product that sells for 6">5 per unit. ?he variable e.penses to make this product are 6K5 per unit. Bi.ed e.penses total 6855&555 per year. (%@ is currently selling 4&555 units each year.

ACCT 211 Chapter 5 Summer 2013 Student Version

Page 14 of 14

". !alculate the number of units that (%@ must sell to breakAeven.

<. !alculate the number of units that (%@ must sell to make 6<55&555 profit.

8. (%@ is considering the purchase of e uipment that will automate its production process. ?his e uipment will increase (%@)s fi.ed e.penses to 6355&555 per year& but the automated process will cause the variable e.penses to drop to 6>5 per unit. How many units will (%@ need to sell to make a 6<55&555 profit if the factory is automated;

3. (%@ estimates that 685&555 of advertising could increase the companyLs sales by "5'. *hould the company purchase the advertisement; (Use the original cost data# don)t consider any changes due to the automation in Muestion 8 above).