Cost-Volume-Profit Relationships Chapter 5

1. Introduction to ManagerialAccounting Brewer, Garrison,Noreen Power Points fromwebsite -adapted by Cynthia Fortin, CPA, CMA Cost-Volume-Profit RelationshipsChapter 5 http://highered.mheducation.com/sites/0078025419/student_view0/chapter5/index.html

2. Video preparation http://video.wileyaccountingupdates.com/2011/03/09/cost-behavior-and-cost-volume-profit-analysis/ http://video.wileyaccountingupdates.com/2011/08/23/cost-volume-profit-calculations/

3. Why is Cost Volume Profit analysis essential for Decision Making? • Helps Managers understandhow • profits are affected by • Price • Volume • Costs (Variable and Fixedexpenses) • Product Mix

5. The Contribution Approach On a per unit basis. If Racing sells an additionalbicycle, $200 additional CM will be generated to cover fixed expenses and add to net operating income (profit).

6. The Contribution Approach How manybicyclesmust Racing Bicycle (RB) sell to coverfixed expenses, therefore making noprofit? RB must generate at least $80,000 to cover fixed expenses. Therefore $80 000/$200 per bicycle = 400 bicycles. At that level of sales, the company makes no profit. Therefore breaks-even.

7. The Contribution Approach If RB sells 400 unitsin a month, it will be operating at the break-even point.

8. Equation Form The contribution format income statement expressed as: Profit= Sales – Variable expenses –Fixedexpenses

9. CVP Relationships in Equation Form Show profit RB earns if it sells 401 units. Profit = Sales – Variable expenses – Fixed expenses $80,000 401 units × $500 401 units × $300 Profit = ($200,500 – $120,300) – $80,000 $200 = ($200,500 – $120,300) – $80,000

10. CVP in Equation Form If the company sells a single product this equation applies Profit = Sales – Variable expenses – Fixed expenses Profit = (P × Q – V × Q) – Fixed expenses Profit = (P – V) Q – Fixed expenses

11. Extended equation Profit = (P – V)*Q – Fixed expenses Profit = (UCM *Q) – Fixed expenses Breakeven is when Profit = $0 $0 = (P-V) Q – Fixed expenses Breakeven (Q) = 0 + Fixed expenses (P-V) or Breakeven (Q) = 0+ Fixed expenses UCM

12. CVP Graphic form 1.Draw Fixed expenses (flat) 2. Plot Total Expenses (start at fixed expenses level) 3. Plot Total Revenues

13. CVP in Graphic Form RB developed contribution margin income statements at 0, 200, 400, and 600 units sold.

14. CVP Graph Dollars Units

15. Breakeven point Intersection where Sales and Total Expenses meet Below BE point => Loss Above BE point => Profit

16. Break-even point(400 units or $200,000 in sales) CVP Graph Profit Area Dollars Loss Area Units

17. The Variable Expense Ratio If CM ratio is 40%, variable expense ratio is 60%

18. Extended equation Profit = (P – V)*Q – Fixed expenses Profit = (UCM *Q) – Fixed expenses Breakeven is when Profit = $0 $0 = (P-V) Q – Fixed expenses Breakeven (Q) = 0 + Fixed expenses (P-V) or Breakeven (Q) = 0+ Fixed expenses UCM

19. Target Profit Analysis Suppose RB’s management wants to know how many bikes must be sold to earn a target profit of $100,000. Q = Target Profit + Fixed expense UCM Q = ($100,000 + $80,000) ÷ $200 Q = 900

20. The Margin of Safety • Actual sales Minus Break-Even Sales • ($250,000 - $200,000)= $50,000 expressed in Dollars • Or Then $50,000/$250,000= 20% of sales, expressed in Percentage of sales • Or 500 units – 400 units = 100 units, expressed in units sold

21. Cost Structure and Profit Stability Managers often have some latitude in determining their organization’s cost structure.

22. Cost Structure and Profit Stability Advantage of a high fixedcost structure Income higher in good yearscompared to companieswith lower proportion offixed costs. Disadvantage of a high fixedcost structure Income lower in bad yearscompared to companieswith lower proportion offixed costs. Companies with low fixed cost structures enjoy greater stability in income across good and bad years.

23. Degree of operating leverage Contribution margin Net operating income Operating Leverage =

24. $100,000 $20,000 =5 Operating Leverage Degree ofOperatingLeverage =

25. Operating Leverage With an operating leverage of 5, if RB increases its sales by 10%, net operating income would increase by 50%. Here’s the verification!

26. Operating Leverage 10% increase in sales from $250,000 to $275,000 . . . . . . results in a 50% increase in income from $20,000 to $30,000.

27. Structuring Sales Commissions Commissions based on sales dollars can lead to lower profits. Let’s look at an example

28. XR7 Turbo Structuring Sales Commissions Pipeline Unlimited produces surfboards. The sales force at Pipeline Unlimited is compensated based on sales commissions. Price $100 CM $ 25 Price $150 CM $ 18

29. Structuring Sales Commissions Which one would you sell? Turbo, of course because commission on $150 is higher than on $100. But, XR7 has a greater CM. Base commissions on contribution margin rather than on selling price alone will generate greaterprofits of a company.

30. The Concept of Sales Mix • Sales mix is the relative proportion in which a company’s products are sold. • Different products have different selling prices, cost structures, and contribution margins. • When a company sells more than one product, break-even analysis becomes more complex as the following example illustrates.

31. The Concept of Sales Mix RB sells bikes and carts. Sales mix 45% to 55%

32. $265,000 $550,000 = 48.2% (rounded) Multiproduct Break-Even Analysis Assume the following

33. Multiproduct Break-Even Analysis $170,00048.2% Dollar sales tobreak even = $352,697 = • Dollar sales to break even Fixed expenses CM =

34. Key Assumptions of CVP Analysis • Selling price constant. • Costs are linear and can be accurately divided into variable (constant per unit) and fixed (constant in total) elements. • In multiproduct companies, the sales mix is constant. • In manufacturing companies, inventories do not change (units produced = units sold).