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Module 15

Module 15. Cost-Volume-Profit Analysis and Planning. Profitability Analysis. What you need to understand to perform profitability analysis. Selling prices Behavior of activity cost drivers. Involves examining the relationships among revenues, costs, and profits

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Module 15

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  1. Module 15 Cost-Volume-Profit Analysis and Planning

  2. Profitability Analysis What you need to understand to perform profitability analysis • Selling prices • Behavior of activity cost drivers Involves examining the relationships among revenues, costs, and profits Widely used in the economic evaluation of existing or proposed products or services Performed before decisions are finalized

  3. CVP Assumptions All costs are classified as fixed or variable. The total cost function is linear within the relevant range. The total revenue function is linear within the relevant range. The analysis is for a single product, or the sales mix of multiple products is constant. There is only one activity cost driver: unit or dollar sales volume.

  4. Example Using the Profit Equation • Estimated costs are: • Required volume to earn $1,000: RV = (FC+DP)/(SP-VCU) RV=($1,780+$1,000)/($1.50-$1.10)=6,950 Chillin’ Time produces and sells one product, ice cream bars, for $1.50 each. To ensure top quality, no inventories are maintained.

  5. Functional Income Statement Example Chillin’ Time Functional Income Statement For a Monthly Volume of 6,950 Ice Cream Bars

  6. Contribution Income Statement Chillin’ Time Contribution Income Statement For a Monthly Volume of 6,950 Ice Cream Bars

  7. Analysis Using Contribution Margin Ratio • Unit contribution margin • Indicates how sensitive an income model is to a change in unit sales • Contribution margin ratio • The portion of every sales dollar contributed toward covering fixed costs and earning a profit

  8. Contribution Margin Example Chillin’ Time’s contribution income appears below: $1.50 – $1.10 = $0.40 Contribution margin per unit: Contribution margin ratio: [$1.50 – $1.10] ÷ $1.50 = 0.2667

  9. Sensitivity Analysis EXAMPLE: If sales increase by 100 ice cream bars per month, by how much will net income increase? 100 × $0.40 = $40 If sales increase by $1,050 per month, by how much will net income increase? $1,050 × 0.2667= $280

  10. Break-Even Point Example Chillin’ Time sells ice cream bars with a $1.10 unit variable cost for $1.50 each. How many bars must it sell to break even? Fixed costs Contribution margin per unit = Chillin’ Time’s Break-Even Unit = Sales Volume $1,780 $1.50 – $1.10 = 4,450 units When Chillin’ Time sells 4,450 ice cream bars per month, it will break even.

  11. Impact of Income Taxes Determining the unit sales volume required to earn a desired after-tax profit: Step 1: Determine the required before-tax profit. Step 2: Substitute the required before-tax profit into the profit formula. Step 3: After-tax profit (1 – tax rate) Before-tax profit = Solve for the required unit sales volume.

  12. Impact of Income Taxes Example Chillin’ Time sells ice cream bars with a $1.10 unit variable cost for $1.50 each. It is subject to a 30 percent income tax rate. How many ice cream bars must Chillin’ Time sell to earn a desired monthly after-tax profit of $840? After-tax profit (1 – tax rate) Before-tax profit = $840 (1 – 0.30) = = $1,200 Target unit sales volume $1,780 + $1,200 $1.50 – $1.10 = = 7,450 ice cream bars

  13. Dollar break-even point Target dollar sales volume Fixed costs Contribution margin ratio = Fixed costs + Desired profit Contribution margin ratio = Multiple Product Break-Even Point Applicable when unit information is not available or when a company sells more than one product.

  14. Sales Mix Analysis • Sales mix • The relative portion of unit or dollar sales that are derived from each product • When sales mix is constant, the basic cost-volume-profit model can be used effectively • When sales mix is not constant, must determine average unit contribution margin or average contribution margin ratio for each alternative mix

  15. Unit Sales Analysis Current sales mix based on units: 5,000 to 5,000 or 1 to 1. Chillin’ Time sells 1 ice cream bar for every popsicle. Chillin’ Time now has two products--ice cream bars and popsicles, with the following information:

  16. Unit Multiproduct Break-Even Example Average contribution margin per unit = [($0.40 × 1) + ($0.25 × 1)] ÷ 2 units= $0.325 Unit break-even point = Fixed costs Contribution margin per unit $1,780 $0.325 = 5,476.9 ≈ 5,477 units = Ice cream bars: 5,477 × 1/2 = 2,739* and Popsicles: 5,477 × 1/2 = 2,739*

  17. Unit Multiproduct Break-Even Example If the sales mix changes to 4:1, how much will the unit break-even sales volume be? Average contribution margin per unit = [($0.40 × 4) + ($0.25 × 1)] ÷ 5 units = $0.37 Fixed costs Contribution margin per unit Unit break-even point with new sales mix = $1,780 $0.37 = Ice cream bars: 4,811 × 4/5 = 3,849 and Popsicles: 4,811 × 1/5 = 962 = 4,811 units

  18. Break-even units Comparing Break-Even Example Sales mix 1 to 1 Ice cream bars: 5,477 × 1/2 = 2,739* and Popsicles: 5,477 × 1/2 = 2739* Sales mix 4 to 1 Ice cream bars: 4,811× 4/5 = 3,849 and Popsicles: 4,811 × 1/5 = 962 The change in sales mix causes the total number of units needed to break even to change because of the different contribution margins for the two products.

  19. Fixed costs Contribution margin per unit = $1,780 0.464 = $3,836 = Dollar Multiproduct Break-Even Example Current sales mix in dollars is 10,000 to 4,000 or about 71% to 29%. How much is the break-even sales volume in dollars? Average contribution margin ratio = $6,500 ÷ $14,000 = 0.464 Dollar break-even point with new sales mix = Ice cream bars: $3,836 × 0.71 = $2,724 and Popsicles: $3,836 × 0.29 = $1,112

  20. Operating Leverage Degree of operating leverage Contribution margin Income before taxes = • What is operating leverage? • Extent to which income will change with a change in sales • High degree of operating leverage • Signals the existence of a high portion of fixed costs

  21. Measuring Expected Change in Profit Taco King and Mexi Land are competitors and reported the same sales revenue and before-tax profit during May: If sales drop by 20% for both, which company suffers more? $18,000 $10,000 $32,000 $10,000 Degree of operating leverage = 1.8 = 3.2 1.8 × 20% = 36% Decline in Profit 3.2 × 20% = 64% Decline in Profit Decrease in profit Mexi Land’s higher operating leverage results in a larger profit decline.

  22. Margin of Safety • Margin of Safety: • Revenues – Breakeven Revenues • Margin of Safety Ratio: • (Sales – BE Sales)/Sales

  23. Margin of Safety Taco King and Mexi Land are competitors and reported the same sales revenue and before-tax profit during May: CM% $18,000/40,000=45% $32,000/40,000=80% Break-even sales $8,000/45%=$17,778 $22,000/80%=$27,500 Margin of Safety $40,000-$17,778=22,222 $40,000-$27,500=$12,500 Margin of Safety Ratio* $22,222/$40,000 = 55.6% $12,500/$40,000=31.3% *Note that MSR = 1/OL

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