V. Cost-Volume-Profit Analysis

1. V.Cost-Volume-Profit Analysis • The rationale • Short run nature of CVP analysis • Time frame during which the company management cannot change the effect of certain past decisions • In practice – less than one year approx. • Common cost behaviour patterns • Fixed costs • Variable costs • Mixed costs (semivariable) • Step costs CVP Analysis

2. Costs patterns • Fixed - stay constant over some relevant range of output. • Variable – vary (in total) directly with changes in volume of production or sales. • Mixed – fixed and variable portion: eg electrical service – fixed when idle, variable when production volume rises. • Step costs – supervisors salaries when additional supervisor is hired. • Curvilinear nature, linear in relevant range CVP Analysis

3. Estimating costs in process costing • Scattergraph – plots actual level of costs per various level of activity • Hi-Low method – uses just the highest and the lowest values – less precise • Regression analysis - fits line within observation. • Estimates are valid in relevant range only! CVP Analysis

4. Contribution margin • The amount by which the revenue exceeds variable costs of producing that revenue. • Per unit or in total sales volume basis • Eg. “Video products” CVP Analysis

5. Break even point • Is the number of units the company must sell and earn profit in order not to incur a loss • Margin of safety (higher than BEP) • Contribution margin x= SP-VC • BEP = F / SP – VC • F fixed costs • SP selling price • VC variable costs CVP Analysis

6. Contribution margin ratio • Cont.margin ratio = Cont.margin/sales or • Q * (SP-VC)/ Q * SP • SP-selling price • VC – variable cost per unit • Q – quantity of units produced/sold • To calculate BEP in dollars: • BEPdollars = Fixed costs/ contribution margin ratio • Used in multi-products companies (eg Multi-product) CVP Analysis

7. Assumptions in C-V-P analysis • Cost can be accurately separated into their fixed and variable components • Fixed cost remains fixed and variable cost per unit remains constant • In multi-product companies production mix remains the same. • C-V-P is a useful tool in “what if” analysis CVP Analysis

8. Operating leverage • Magnitude of fixed versus magnitude of variable costs in a firm cost structure • High fixed costs – high operating leverage • Level of operating leverage affects the change in profit when sales change • The greater the leverage the higher the decrease or increase of profit • Concept of Financial leverage and the correspondence CVP Analysis

9. Degree of operating leverage (DOL) • Change in EBIT compared to Change in sales • DOL = Q(SP-VC)/(Q(SP-VC)-F) • Q quantity of product units produced and sold • SP selling price per unit • VC variable costs per unit • F fixed costs (per period) • Relation to the risk of corporation • Degree of operating leverage and degree of financial leverage - correspondence CVP Analysis

10. Discussion questions • Explain and describe behaviour cost patterns • Separate mixed costs into fixed and variable components using the scatter diagram and high-low method • Clarify the concept of relevant range • Explain the relation among costs, volume, revenue and profits • Explain break-even point and how you find that. CVP Analysis

11. Discussion questions 2 • Explain the concept margin of safety • List and explain the assumptions underlying cost volume profit analysis • Explain how computer spreadsheets expand your capability to use cost volume profit analysis • Explain the impact of automation on fixed variable cost relationship CVP Analysis

12. Discussion questions 3 A. Using the following data, calculate the sales revenue needed to break even: • Selling price per unit: $10 • Fixed costs $ 20 000 • Variable costs per unit $ 6 B. Using the following data, calculate the contribution margin • Selling price per unit: $20 • Fixed costs $ 4 • Variable costs per unit $ 6 CVP Analysis