CVP Analysis

How can managers of 6Ten stores see the effects of selling a new flavor of milk during the morning rush hour, increasing milk prices, or opening stores in a new area?
Cost-volume-profit (CVP) analysis examines the behavior of total revenues, total costs, and operating income as changes occur in - the output level, - the selling price, - the variable cost per unit, and/or - fixed costs of a product

Managers use CVP analysis to help answer questions such as: - How will total revenue and total costs be affected if the output level changes? - If we raise or lower selling price, how will that affect the output level? - If we expand our business into foreign markets, how will that affect costs, selling price, and output level?

CVP assumptions: - Changes in the levels of revenue and costs arise only because of changes in the number of product/service units produced and sold. The number of output units is the only revenue driver and the only cost driver - Total costs can be separated into a fixed component and a variable component - Selling price, vc per unit and fixed costs in total are known and constant

- Operating income = total revenues from operations cost of goods sold and operating costs
- Net income is operating income plus non-operating revenues (such as interest income) minus non-operating costs (such as interest cost) minus income taxes - Net income = operating income + non-operating revenues non-operating costs income taxes

Mamta plans to sell Do-All Software, a home-office software package, at a two-day computer convention in Ahmedabad. Mamta can purchase this software from a computer software wholesaler at Rs.120 per package, with the privilege to return all unsold packages and receive a full Rs.120 refund per package. The package will be sold for Rs.200 each. She has already paid Rs.2,000 to Computer Conventions for the booth rental for the twoday convention. Assume that there are no other costs. Booth rental cost of Rs.2,000 is a fixed cost The cost of the package Rs.120 is a variable cost

The difference between total revenues and total variable costs is called contribution margin
Contribution margin = total revenues total variable costs Contribution margin per unit = selling price variable costs per unit Contribution margin = contribution margin per unit * number of units sold

0 Revenues at Rs.200 per package Variable costs at Rs.120 per package Rs.0 0 0 2,000

1 Rs.200 120 80 2,000

5 600 400 2,000

25 3,000 2,000 2,000

40 Rs.8,000 4,800 3,200 2,000

Rs.1,000 Rs.5,000

CM at Rs.80 per package Fixed costs

Operating income

(2,000)

(1,920)

(1,600)

1,200

CM percentage (CM ratio) / PV ratio = CM per unit / selling price OR = total CM / total revenue
CM percentage = 80 / 200 = 0.40 or 40%

Breakeven Point (BEP) Quantity of output sold at which total revenues equal total costs Quantity of output sold at which operating income is 0 BEP tells managers how much output they must sell to avoid a loss

Breakeven Point (BEP) Revenue Total Costs = Operating Income Revenue VC FC = OI (SP * Q) (VCU * Q) FC = OI (SP * Q) (VCU * Q) = FC + OI (SP VCU) Q = FC + OI Q = (FC + OI) / (SP VCU) Q = (FC + OI) / CMU At BEP, operating income is 0 Q = FC / CMU
Breakeven number of units = fixed costs / CM per unit

Breakeven Point (BEP) Breakeven number of units = fixed costs / CM per unit Breakeven number of units = 2,000 / 80 = 25 packages
25

Revenues at Rs.200 per package Variable costs at Rs.120 per package

CM at Rs.80 per package Fixed costs Operating income

Rs.5,000

3,000
2,000 2,000 0

Breakeven Point (BEP) Breakeven Revenues = FC / CM % = 2,000 / 0.40 = Rs.5,000

25 Revenues at Rs.200 per package Variable costs at Rs.120 per package CM at Rs.80 per package Fixed costs Operating income Rs.5,000 3,000

2,000
2,000 0

Breakeven Chart
Total Revenue

Operating income

Rs.2,000 Breakeven Revenue Rupees

BEP = 25 units

Total Cost

VC

FC FC 25 units Operating loss Units sold

Target Operating Income How many units must be sold to earn an operating income of Rs.1,200 (SP * Q) (VCU * Q) FC = OI (200 * Q) (120 * Q) 2,000 = 1,200 200 Q 120 Q = 3,200 Q = 3,200 / 80 = 40 units or packages Desired sales to earn target OI = (FC + TOI) / CMU = (2,000 + 1,200) / 80 = 40 units Revenue needed to earn TOI = (FC + TOI) / CM% = (2,000 + 1,200) / 0.40 = Rs.8,000

Target Operating Income

40
Revenues at Rs.200 per package Variable costs at Rs.120 per package CM at Rs.80 per package Fixed costs Operating income Rs.8,000 4,800 3,200

2,000
1,200

Target Net Income How many units must be sold to earn a net income of Rs.960 at 40% tax rate? Revenue VC FC = OI Target Net Income = OI Income Tax Target NI = OI (OI * tax rate) Target NI = OI (1 tax rate) OI = target NI / (1 tax rate) Revenue VC FC = target NI / (1 tax rate) SP * Q VCU * Q FC = target NI / (1 tax rate) 200 Q 120 Q 2,000 = 960 / (1 0.40) 80 Q 2,000 = 1,600 Q = 3,600 / 80 = 45 units

Target Net Income

TNI FC +

Q =

1 tax rate

CMU 960

2,000 +
Q = 80

1 0.40

= 45 units

Target Net Income

TNI Desired revenue = FC + 1 tax rate

CM % 960

2,000 +
Q = o.40

1 0.40

= Rs.9,000

Target Net Income

45 Revenues at Rs.200 per package Variable costs at Rs.120 per package CM at Rs.80 per package Fixed costs

Rs.9,000 5,400
3,600 2,000 1,600 640 960

Operating income
Income tax @ 40% Net income

What will be effect on BEP when focusing the analysis on target net income instead of target operating income?

Using CVP Analysis for decision making Different choices can affect selling prices, VC per unit, FC, units sold, and OI CVP Analysis helps managers make this decision by estimating the expected long-term profitability of different choices CVP Analysis also helps managers decide how much to advertise whether to expand into new market how to price the product CVP Analysis evaluates how OI will be affected if the original predicted data are not achieved

Decision to advertise Suppose Mamta anticipates to sell 40 units At a sale of 40 units, Mamtas OI would be Rs.1,200 Mamta is considering placing an advertisement in Ahmedabad Mirror describing the product, its features, and her participation in Computer Conventions The advertisement will cost Rs.500 She anticipates that advertising will increase sales by 10% to 44 packages Should Mamta advertise?

Decision to advertise
40
Revenues at Rs.200 per package Variable costs at Rs.120 per package CM at Rs.80 per package Fixed costs Operating income 40 CM at Rs.80 per package Fixed costs Operating income Rs.3,200 2,000 1,200 Rs.8,000 4,800 3,200

44
Rs.8,800 5,280 3,520 2,500 1,020 Difference

2,000
1,200 44

Rs.3,520
2,500 1,020

Rs.320
500 (180)

Decision to reduce selling price Having decided not to advertise, Mamta is contemplating whether to reduce selling price to Rs.175 At this price she anticipates to sell 50 units At this quantity, the software whole-seller who supplies DoAll Software will sell packages to Mamta for Rs.115 per unit instead of Rs.120 Should Mamta reduce the selling price? New CM per unit= 175 115 = Rs.60 CM from lowering selling price 50 units * Rs.60 Rs.3,000 Original CM 40 units * Rs.80 Rs.3,200 Change in CM from lowering selling price (Rs.200)

Decision to reduce selling price Mamta can examine other alternatives to increase OI Such as, Simultaneously increasing advertising costs and lowering prices In each case, she will compare the changes in CM (through the effects on SP, VC and quantities of units sold) to the changes in FC

Alternative FC & VC structures Suppose Computer Conventions offers Mamta three rental alternatives: Option 1 Rs.2,000 fixed fee Option 2 Rs.800 fixed fee plus 15% of convention revenues Option 3 25% of convention revenues with no fixed fee

Option # 1 (Rs.2,000 fixed fee as booth rental)

0 (Rs.) Revenues at Rs.200 per package Variable costs at Rs.120 per package CM at Rs.80 per package Fixed costs Operating income 0 16 (Rs.) 3,200 20 (Rs.) 4,000 25 (Rs.) 5,000 40 (Rs.) 8,000 60 (Rs.) 12,000

0
0 2,000 (2,000)

1,920
1,280 2,000 (720)

2,400
1,600 2,000 (400)

3,000
2,000 2,000 0

4,800
3,200 2,000 1,200

7,200
4,800 2,000 2,800

Option # 2 (Rs.800 fixed fee plus 15% of convention revenues as booth rental) Selling price Rs.200 VC PU= purchase price 120 + rent 15% of revenue VC PU = 120 + 30 = Rs.150 FC Rs. 800
0 (Rs.) Revenues at Rs.200 per package Variable costs at Rs.150 per package 0 0 0 800 (800) 16 (Rs.) 3,200 2,400 800 800 0 20 (Rs.) 4,000 3,000 1,000 800 200 25 (Rs.) 5,000 3,750 1,250 800 450 40 (Rs.) 8,000 6,000 2,000 800 1,200 60 (Rs.) 12,000 9,000 3,000 800 2,200

CM at Rs.50 per package

Fixed costs Operating income

Option # 3 (25% of convention revenues with no fixed fee) Selling price Rs.200 VC PU= purchase price 120 + rent 25% of revenue VC PU = 120 + 50 = Rs.170 FC Rs. 0
0 (Rs.) Revenues at Rs.200 per package Variable costs at Rs.170 per package CM at Rs.30 per package Fixed costs Operating income 0 0 0 16 (Rs.) 3,200 2,720 480 20 (Rs.) 4,000 3,400 600 25 (Rs.) 5,000 4,250 750 40 (Rs.) 8,000 6,800 1,200 60 (Rs.) 12,000 10,200 1,800

0
0

0
480

0
600

0
750

0
1,200

0
1,800

SP VC PU CMPU Option 1 Rs. 200 Rs.120 = Rs.80 Option 2 Rs.200 Rs.150 = Rs.50 Option 3 Rs.200 Rs.170 = Rs.30 Option 1 has highest CM per unit, because of its low VC per unit Once FC are fully recovered at sale of 25 units, each additional unit sold adds Rs.80 of CM and, therefore, Rs.80 of OI per unit

The risk-return tradeoff across alternative cost structures can be measured as operating leverage Operating leverage describes the effects that FC have on changes in operating income
Degree of operating leverage = CM / OI

Degree of operating leverage at sales of 40 units for three rental options Op 1 Op 2 Op 3 CM PU 80 50 30 CM 3,200 2,000 1,200 OI 1,200 1,200 1,200 Degree of operating leverage 3,200 / 1,200 2,000 / 1,200 1,200 / 12,00 2.67 1.67 1.00 DOL is specific to a given level of sales as a starting point. If the starting point changes, DOL changes. For example, for a sale of 50 units, for option 1 DOL = CM 4,000 / OI 2,000 = 2.00

Effect of time horizon

In CVP analysis we assume that costs are either variable or fixed But whether a cost is variable or fixed depends on the time period for a decision The shorter the time horizon, the higher the % of total costs considered as fixed Suppose an Indian Airlines plane will depart from its gate in the next 60 minutes and currently has 20 seats unsold A potential passenger arrives from a competing airline company. What are the VC to IA of placing one more passenger in an otherwise empty seat? VC (such as one more meal) would be negligible Virtually all costs in this decision situation are fixed, such as baggage handling costs, crew costs and corporate office costs

Effect of time horizon

Alternatively, suppose IA wants to decide whether to include one more city in its routes This decision may have a one year planning horizon Many more costs, including crew costs, baggage handling costs and air port fees, would be regarded as variable, and fewer costs would be regarded as fixed costs in this decision, such as corporate office costs This example shows that whether a cost is fixed depends heavily on the relevant range, the length of time horizon being considered, and the specific decision situation

Effect of sales mix

Mamta is now budgeting for next convention. She plans to sell two different software products- Do-All and Superword
Do-All Units sold Revenues VC Rs.200 PU Rs.120 PU Rs.100 PU Rs.70 PU Superword Do-All 60 Rs. 12,000 7,200 4,800 Superword 40 Rs. 4,000 2,800 1,200 Total

100
Rs. 16,000 10,000 6,000

CM
Fixed costs Operating Income

Rs.80 PU

Rs.30 PU

4,500
1,500

Effect of sales mix

What is the break even point? Composite Contribution margin ratio 6,000 / 16,000 = 37.5% BE Revenue = FC 4,500 / CM % 0.375 = Rs.12,000 Sales mix 12,000 : 4,000 3:1

Break Even Revenue Do-All Rs. 9,000 Break Even Point 45

Super-word Rs. 3,000 30

Effect of sales mix

Alternative sales mixes can have a CM of Rs.4,500 Do-All 54 48 42 36 30 24 18 12 6 0 Superword 6 22 38 54 70 86 102 118 134 150 Total 60 70 80 90 100 110 120 130 140 150

Multiple Cost Drivers

Mamta is selling only one package, i.e. Do-All In addition of purchase cost, she also incurs Rs.10 per customer document preparation cost. Revenue Less: Variable costs Rs.200 * units sold

Rs.120 * units sold Rs.10 * no. of customers

CM Less: fixed costs OI Rs.2,000

Multiple Cost Drivers

If Mamta sold 40 packages to 25 custoemrs OI = 40 * 200 40 * 120 25 * 10 2,000 = 8,000 4,800 250 2,000 = Rs.950 If Mamta sold 40 packages to 40 custoemrs OI = 40 * 200 40 * 120 40 * 10 2,000 = 8,000 4,800 400 2,000 = Rs.800 There is no unique BEP, when there are multiple cost drivers Mamta will break even if she sells 26 packages to 8 customers or 27 packages to 16 customers

 B. Obama is a newly elected leader of the Democratic Party. His attitude has left many an opponent on talk shows feeling run over by a Mack truck. Media Publishers is negotiating to publish Obamas Manifesto, a new book that promises to be instant best seller. The fixed cost of producing and marketing the book will be $500,000. The variable costs of producing and marketing will be $4.00 per copy sold. These costs are before any payment to Obama. Obama negotiates an upfront payment of $3million, plus a 15% royalty rate on the net sales price of each book. The net sales price is the listed book price of $30, minus the margin paid to the bookstore to sell the book. The normal bookstore margin of 30% of the listed bookstore price is expected to apply. How many copies must Media Publishers sell to (a) break even and (b) earn a target operating income of $2 million? Examine the sensitivity analysis of the BEP to the following changes: 1.Decreasing the normal bookstore margin to 20% of the listed bookstore price of $30. 2.Increasing the listed bookstore price to $40 while keeping the margin at 30%.

PDPU has an annual budget of Rs.1,00,00,000 for athletic scholarships. Each athletic scholarship is Rs.40,000 per year. Fixed operating costs of the athletic scholarship programme are Rs.12,00,000 and variable operating costs are Rs. 4,000 per scholarship offered. Determine the number of athletic scholarships PDPU can offer each year. Suppose the total budget for next year is reduced by 22%. Fixed costs are to remain the same. Calculate the number of athletic scholarships that PDPU can offer next year. As in above requirement, assume a budget reduction of 22% and the same fixed costs. If PDPU wanted to offer the same number of athletic scholarships as it did in first requirement, calculate the amount that will be paid to each student who receives a scholarship.