Cost-Volume-Profit Relationships

1. Cost-Volume-Profit Relationships UAA – ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee

2. Introduction • We have learned . . . • How to identify costs as fixed, variable, and mixed; • How each of these behave when changes take place; and • How to separate them into their component parts. ACCT 202 - UAA - Fall 2004

3. Introduction • Understanding these relationships help managers to; • Predict future conditions (planning); and • Explain, evaluate, and act on past results (control) ACCT 202 - UAA - Fall 2004

4. Introduction Today we will focus on gaining an understanding of how . . . • Costs • Volume, and • Profits Interact ACCT 202 - UAA - Fall 2004

5. Cost-Volume-Profit (CVP) • CVP is the systematic examination of the relationships among . . . • Selling prices, • Volume of Sales and Production • Cost, • Expenses, and • Profits ACCT 202 - UAA - Fall 2004

6. Output Sales Price Variable Costs Fixed Costs Graphically As changes occur here. What happens here? Total Revenues Total Revenue Output Sales Price Total Cost Total Cost Variable Costs Operating Income Fixed Costs Operating Income 4

7. CVP - For-Profit Firms • How many photocopies must the College Avenue Copy Shop produce to earn a profit of $20,000? • At what sales volume will Burger King’s total costs and total revenues equal? ACCT 202 - UAA - Fall 2004

8. CVP - For-Profit Firms • What will happen to profits in Joe’s Diner if . . . • There is a 20% increase in the cost of food; and • A 10% increase in the selling price of meals? ACCT 202 - UAA - Fall 2004

9. CVP - Not-For-Profit Firms • How many meals can the Salvation Army serve with an annual budget of $150,000? • How many tickets must be sold for the benefit concert to raise $15,000? ACCT 202 - UAA - Fall 2004

10. CVP is Useful in . . . • Choice of product lines • Pricing of products • Developing marketing strategies • Utilization of productive facilities ACCT 202 - UAA - Fall 2004

11. Traditional Statement • Costs are grouped by functional classifications - such as: • Production, • Selling & Administration • With both fixed and variable costs being included in each category. ACCT 202 - UAA - Fall 2004

12. Sales $xxx COGS (xx) Gross Margin $xxx Selling Exp. Admin. Exp (xx) (xx) Net Income $xxx Absorption-Costing I/S Production FC & VC Selling FC & VC Administrative FC & VC

13. Contribution Format • The focus of the contribution format income statement is the contribution margin . . . Contribution Margin = Net Sales - Variable Costs ACCT 202 - UAA - Fall 2004

14. Contribution Format I/S • Groups costs by behavior: • Fixed, and • Variable • Rather than into the functional categories of production, marketing and administration. ACCT 202 - UAA - Fall 2004

15. Sales $xxx Cont. Margin $xxx Net Income $xxx Variable-Costing I/S Variable Costs (xx) Fixed Costs (xx)

16. Sales $xxx Sales $xxx COGS (xx) Variable Costs (xx) Gross Margin $xxx Cont. Margin $xxx Operating Exp (xx) Fixed Costs (xx) Net Income $xxx Net Income $xxx Income Statements . . . Traditional Contribution Format

17. Sales $900,000 Cost of Sales Direct Materials $100,000 Direct Labor 160,000 Mfg. Overhead 100,000 361,000 VC=$55,000 FC=$45,000 Marketing Costs Variable 18,000 Fixed 82,000 100,000 Admin. Costs (Fixed) $150,000 Sourdough Alaska, Inc.

18. Sales $900,000 100% Cost of Sales Direct Materials $100,000 Direct Labor 160,000 Mfg. Overhead 100,000 360,000 40% Gross Margin $540,000 60% Marketing/Admin Costs Marketing Costs $100,000 Administrative Costs 150,000 250,000 Net Income $290,000 Sourdough Alaska, Inc. Traditional Income Statement For Year Ended December 31, 2002

19. What if . . . • You were asked to project the effect on net income of: • A 20% increase in sales volume; • With no change in selling prices. • How would you go about doing it? ACCT 202 - UAA - Fall 2004

20. Sales $900,000 100% Cost of Sales Direct Materials $100,000 Direct Labor 160,000 Mfg. Overhead Variable Mkt. Exp 18,000 55,000 $333,000 37% Contribution Martin $567,000 63% Fixed Costs Manufacturing Marketing 45,000 82,000 Administrative 150,000 277,000 Sourdough Alaska, Inc. Contribution Format Income Statement For Year Ended December 31, 2002 Net Income $290,000

21. NOW . . . What if . . . • You were asked to project the effect on net income of: • A 20% increase in sales volume; • With no change in selling prices. • How would you go about doing it? ACCT 202 - UAA - Fall 2004

22. Sales ($900,000 x 120%) $1,080,000 Less: VC: ($333,000 x 120%) 399,600 Contribution Margin 688,400 Less: Fixed Costs 277,000 Projected Net Income 403,400 Less Original NI Projection 290,000 Projected Increase in Net Income $113,400 Sourdough Alaska, Inc. Projected Increase in Net Income For Year Ended December 31, 2002

23. Breakeven Analysis 2 • Can be computed two ways: • The equation method • The contribution margin method ACCT 202 - UAA - Fall 2004

24. Breakeven Analysis 2 • Can be computed in two forms: • Number of units required to break even; or • Sales dollars required to break even. ACCT 202 - UAA - Fall 2004

25. The Equation Method Exhaustion Unlimited – An Illustration

26. Exhaustion Unlimited • Exhaustion Unlimited makes and distributes high end exercise equipment. • One of their best selling products is an exercise bike –Model IMATRD-1 ACCT 202 - UAA - Fall 2004

27. Exhaustion Unlimited Info

28. The equation method centers on the contribution approach to the income statement. Profit = Sales - VC - FC Sales = Profit + VC + FC

29. Sales = Profit + VC + FC • At breakeven profit = 0 Sales = Profit + VC + FC • The equation becomes: BES = VC + FC

30. Use our BE Equation; and • Let X = BE Point in Bikes Sales VC FC

31. Use our BE Equation; and • Let X = BE Point in Sales $ Sales VC FC

33. The Unit Contribution Method Exhaustion Unlimited – An Illustration

34. Unit-Contribution Method • Is a variation of the equation method. • The method may be just a bit more intuitive than the equation method. ACCT 202 - UAA - Fall 2004

35. Unit-Contribution Method • The approach centers on the idea that each unit sold provides a certain amount of CM that goes toward covering fixed costs. ACCT 202 - UAA - Fall 2004

36. Unit-Contribution Method • The Formula . . . ACCT 202 - UAA - Fall 2004

37. Fixed Costs BEP in Units Unit CM

38. Fixed Costs BEP in $ CM %

39. Unit Contribution Method • Let’s look at a series of income statements that graphically point out the concept of a contribution margin. ACCT 202 - UAA - Fall 2004

41. Break-Even Analysis Target Net Profit Analysis

42. Target Net Profit Analysis • A firm’s targeted NI is the amount of income the firm wishes to make . . . • Pre-Tax OI; or • After-Tax NI ACCT 202 - UAA - Fall 2004

43. Target Net Profit Analysis • Recall the BE formula: Sales = FC + VC + Profits ACCT 202 - UAA - Fall 2004

44. Target Net Profit Analysis • Using data from Exhaustion Unlimited. • Assume the firm wants to make a before-tax profit of $40,000. ACCT 202 - UAA - Fall 2004

45. Exhaustion Unlimited Info

46. Use our BE Equation; and • Let X = BE Point in Bikes Sales VC FC Desired Profit

47. Use our BE Equation; and • Let X = BE Point in Sales $ Sales VC FC Desired Profit

49. Target Before-Tax Profit Analysis The Unit Contribution Method

50. Unit-Contribution Method • The Formula . . . Add Targeted Before-Tax OI (TI) to the Fixed Expenses Add Targeted Before-Tax OI (TI) to the Fixed Expenses ACCT 202 - UAA - Fall 2004