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Understanding Cost-Volume-Profit Analysis and Break-Even Point Calculations

This chapter delves into the importance of variable costing in break-even analysis, calculating break-even points, and understanding cost-volume-profit analysis in single and multiproduct environments. It covers margin of safety, operating leverage, and key assumptions underlying cost-volume-profit analysis.

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Understanding Cost-Volume-Profit Analysis and Break-Even Point Calculations

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  1. Cost Accounting Foundations and Evolutions Kinney, Prather, Raiborn Chapter 9 Break-Even Point and Cost-Volume-Profit Analysis

  2. Learning Objectives (1 of 2) • Explain why variable costing is more useful than absorption costing for break-even and cost-volume-profit analysis • Calculate the break-even point using formulas, graphs, and income statements • Explain how companies use cost-volume-profit analysis

  3. Learning Objectives (2 of 2) • Explain break-even and cost-volume-profit analysis for single-product and multiproduct environments • Describe how businesses use margin of safety and operating leverage concepts • List the underlying assumptions of cost-volume-profit analysis

  4. Variable Costing and CVP • Variable costing • Separates costs into fixed and variable components • Shows fixed costs in lump-sum amounts, not on a per-unit basis • Does not allow for deferral/release of fixed costs to/from inventory when production and sales volumes differ

  5. Equations • Break-even point Total Revenues = Total Costs Total Revenues - Total Costs = Zero Profit

  6. Equations Contribution Margin (CM) Sales Price - Variable Cost = CM per unit Revenue - Total Variable Costs = CM in total Contribution Margin Ratio (CM%) Sales Price – Variable Cost Sales Price

  7. Traditional CVP Graph Total Revenues BEP Total Costs Total $ Profit Activity Level Loss

  8. Profit-Volume Graph $ BEP Activity Level Fixed Costs Profit Loss

  9. Sales Less Total variable costs Contribution Margin Less Total fixed costs Profit before taxes Income taxes Profit after taxes B/E $ 150,000 (50,000) $ 100,000 (100,000) -0- Income Statement Approach Target Profit $ 240,000 (80,000) $ 160,000 (100,000) 60,000 (24,000) $ 36,000 Proof of CVP and/or graph solutions

  10. Incremental Analysis • Focuses only on factors that change from one option to another • Changes in revenues, costs, and/or volume • Break-even point increases when • fixed costs increase • sales price decreases • variable costs increase

  11. Multiproduct Cost-Volume-Profit Analysis • Assumes a constant product sales mix • Contribution margin is weighted on the quantities of each product included in the “bag” of products • Contribution margin of the product making up the largest proportion of the bag has the greatest impact on the average contribution margin of the product mix

  12. Multiproduct Cost-Volume-Profit Analysis Sales mix 3 2 Breakeven “bag” x 1,000 3,000 x 1,000 2,000 Breakeven units To break even sell 3,000 sprays and 2,000 liquids

  13. Margin of Safety • How far the company is operating from its break-even point • Budgeted (or actual) sales after the break-even point • The amount that sales can drop before reaching the break-even point • Measure of the amount of “cushion” against losses • Indication of risk

  14. Margin of Safety in units or dollars • Actual unit sales or dollar sales Margin of Safety • Units Actual units - break-even units • Dollars Actual sales dollars - break-even sales dollars • Percentage

  15. Operating Leverage • Relationship of variable and fixed costs • Effect on profits when volume changes • Cost structure strongly influences the impact that a change in volume has on profits

  16. High Operating Leverage Low variable costs High fixed costs High contribution margin High break-even point Sales after break-even have greater impact on profits Low Operating Leverage High variable costs Low fixed costs Low contribution margin Low break-even point Sales after break-even have lesser impact on profits Operating Leverage

  17. Cost-Volume-Profit Assumptions • Company is operating within the relevant range • Revenue and variable costs per unit are constant • Total contribution margin increases proportionally with increases in unit sales • Total fixed costs remain constant • Mixed costs are separated into variable and fixed elements

  18. Cost-Volume-Profit Assumptions • No change in inventory (production equals sales) • No change in capacity • Sales mix remains constant • Anticipated price level changes included in formulas • Labor productivity, production technology, and market conditions remain constant

  19. Questions • What is the difference between absorption and variable costing? • How do companies use cost-volume-profit analysis? • What are the underlying assumptions of cost-volume-profit analysis?

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