Cost-Volume-Profit Relationships Chapter 5

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

2. Why is Cost Volume Profit analysis essential for Decision Making? • Helps Managers understand how • profits are affected by • Price • Volume • Costs (Variable and Fixed expenses) • Product Mix

3. What’s left to cover fixed expenses and profit

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

5. 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.

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

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

8. 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

9. 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) x Q – Fixed expenses

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

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

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

13. CVP Graph Dollars Units

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

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

16. The Variable Expense Ratio If CM ratio is 40%, variable expense ratio is 100% - 40% = 60%

17. 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

18. Target Profit Analysis Q = Target Profit + Fixed expense UCM 900 = ($100,000 + $80,000) ÷ $200 Or at what level of sales? $ = Target Profit + Fixed expense CM % $450,000 = ($100,000 + $80,000) ÷ 40% Suppose RB’s management wants to know how many bikes must be sold to earn a target profit of $100,000.

19. Margin of safety The margin of safety is the excess of budgeted or actual sales dollars over the break-even volume of salesdollars. It is the amount by which sales can drop before losses are incurred. The higher the margin of safety, the lower the risk of not breaking even and incurring a loss.

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

21. Cost Structure and Profit Stability Cost structure refers to the relative proportion of fixed and variable costs in an organization. Managers often have some latitude in trading off between these two types of costs. For example, fixed investments in automated equipment can reduce variable labor costs.

22. Cost Structure and Profit Stability Sales 100 200 Variable 20 40 CM 80 160 Fix 50 50 NOI 30 110 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. Sales 100 60 Variable 20 12 CM 80 48 Fix 50 50 NOI 30 18 Companies with low fixed cost structures enjoy greater stability in income across good and bad years.

23. Operating leverage A lever is a tool for multiplying force. Using a lever, a massive object can be moved with only a modest amount of force. In business, operating leverage serves a similar purpose.

24. Operating leverage • Operating leverageis a measure of how sensitive net operating income is to a given percentage change in dollar sales. • Operating leverage acts as a multiplier. • If operating leverage is high, a small percentage increase in sales can produce a much larger percentage increase in net operating income.

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

26. $100,000 $20,000 =5 Operating Leverage Degree ofOperatingLeverage =

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

28. 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.

29. Operating leverage The degree of operating leverage can be used to quickly estimate what impact various percentage changes in sales will have on profits, without the necessity of preparing detailed income statements.

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

31. 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

32. 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.

33. 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.

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

35. Multiproduct Break-Even Analysis Assume the following

36. Multiproduct Break-Even Analysis $170,000/ 48.2% Dollar sales tobreak even = = $352,697 • Dollar sales to break even Fixed expenses / CM % =

37. 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).