Cost-Volume-Profit Analysis

1
Cost-Volume-Profit Analysis

• Chapter 3

2
Outline

• CVP assumptions terminology
• BEP solution
• Target operating income
• Target net income
• Margin of Safety
• Operating Leverage
• CM vs. GM

3
Asumptions

• Four assumptions
• underlying cost-volume-profit
• (CVP) analysis are presented
• in the text.
• We will assume that they hold here.

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Cost-Volume-Profit Terminology
Operating income Total revenues from
operations Cost of goods sold and operating
costs (excluding income taxes)
Net income Operating income Income taxes
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(CVP) Analysis Example
Assume that the Pants Shop can purchase pants for
32 from a local factory other variable
costs amount to 10 per unit.
The local factory allows the Pants Shop to return
all unsold pants and receive a full 32 refund
per pair of pants within one year.
The average selling price per pair of pants is
70 and total fixed costs amount to 84,000.
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(CVP) Analysis Example
How much revenue will the business receive
if 2,500 units are sold?
2,500 70 175,000
How much variable costs will the business incur?
2,500 42 105,000
175,000 105,000 84,000 (14,000)
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(CVP) Analysis Example
What is the contribution margin per unit?
70 42 28 contribution margin per unit
What is the total contribution margin when 2,500
pairs of pants are sold?
2,500 28 70,000
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(CVP) Analysis Example
Contribution margin percentage (contribution margi
n ratio) is the contribution margin per unit
divided by the selling price.
What is the contribution margin percentage?
28 70 40
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(CVP) Analysis Example
If the business sells 3,000 pairs of
pants, revenues will be 210,000 and
contribution margin would equal 40 210,000
84,000.
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BEPs

• Determine the breakeven point
• and output level needed to achieve
• a target operating income using
• the equation,
• (2) contribution margin, and
• (3) graph methods.

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Breakeven Point
Variable expenses
Fixed expenses
Sales


Total revenues Total costs Rev VC FC 0
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Abbreviations
SP Selling price
VCU Variable cost per unit
CMU Contribution margin per unit
CM Contribution margin percentage
FC Fixed costs
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Abbreviations
Q Quantity of output units sold (and
manufactured)
OI Operating income
TOI Target operating income
TNI Target net income (after tax)
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Equation Method
(Selling price Quantity sold) (Variable unit
cost Quantity sold) Fixed costs Operating
income
Let Q number of units to be sold to break even
70Q 42Q 84,000 0 28Q 84,000 Q
84,000 28 3,000 units
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Contribution Margin Method
84,000 28 3,000 units
84,000 40 210,000
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Graph Method
Breakeven
Revenue
Total costs
Fixed costs
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Target Operating Income
(Fixed costs Target operating income) divided
either by Contribution Margin percentage or
Contribution Margin per unit
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Target Operating Income
Assume that management wants to have an operating
income of 14,000.
How many pairs of pants must be sold?
(84,000 14,000) 28 3,500
What dollar sales are needed to achieve this
income?
(84,000 14,000) 40 245,000
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Income Taxes

• Understand how income
• taxes affect CVP analysis.

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Target Net Incomeand Income Taxes Example
Management would like to earn an after tax income
of 35,711.
The tax rate is 30.
What is the target operating income?
Target operating income Target net income (1
tax rate)
TOI 35,711 (1 0.30) 51,016
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Target Net Incomeand Income Taxes Example
How many units must be sold?
Revenues Variable costs Fixed costs Target
net income (1 tax rate)
70Q 42Q 84,000 35,711 0.70
28Q 51,016 84,000
Q 135,016 28 4,822 pairs of pants
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Target Net Incomeand Income Taxes Example
Proof Revenues 4,822 70 337,540 Variable
costs 4,822 42 202,524 Contribution
margin 135,016 Fixed costs
84,000 Operating income 51,016 Income
taxes 51,016 30 15,305 Net income
35,711
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Operating Leverage
Operating leverage describes the effects
that fixed costs have on changes in
operating income as changes occur in units sold.
Organizations with a high proportion of
fixed costs have high operating leverage.
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Operating Leverage Example
Degree of operating leverage Contribution
margin Operating income
What is the degree of operating leverage of the
Pants Shop at the 3,500 sales level under two
different arrangements?
Existing arrangement 3,500 28 98,000
contribution margin
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Operating Leverage Example
98,000 contribution margin 84,000 fixed
costs 14,000 operating income
98,000 14,000 7.0
New arrangement Assume Unit Variable Costs 35
and Fixed Cost 114,000 3,500 35 122,500
contribution margin
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Operating Leverage Example
122,500 contribution margin 114,000 fixed
costs 8,500
122,500 8,500 14.4
The degree of operating leverage at a given
level of sales helps managers calculate the
effect of fluctuations in sales on operating
income. E.g., above a 10 increase in sales will
yield a 144 increase in op. income! What is
operating leverage if fixed costs 0? As sales
increase, what happens to op. leverage?
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Contribution Margin versusGross Margin
Contribution income statement emphasizes contribut
ion margin.
Financial accounting income statement emphasizes
gross margin.
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GM versus CM

• The difference between GM and CM all is in how
  you account for
• Fixed mfg. costs (in CoGS, NOT in VC)
• Variable non-mfg. costs (in VC, NOT in CoGS)
• GM Rev. CoGS
• CM Rev. VC
• Margins are usually referred to in finance.
  What margins are they usually referring to?

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End of Chapter 3