Title: Cost-Volume-Profit Relationships
1Cost-Volume-Profit Relationships
2LEARNING OBJECTIVES
After studying this chapter, you should be able
to
- 1. Explain how changes in activity affect
contribution margin. - 2. Compute the contribution margin ratio (CM)
ratio and use it to compute changes in
contribution margin and net income. - 3. Show the effects on contribution margin of
changes in variable costs, fixed costs, selling
price and volume. - 4. Compute the break-even point by both the
equation method and the contribution margin
method.
3LEARNING OBJECTIVES
After studying this chapter, you should be able
to
- 5. Prepare a cost-volume-profit (CVP) graph and
explain the significance of each of its
components. - 6. Use the CVP formulas to determine the activity
level needed to achieve a desired target profit. - 7. Compute the margin of safety and explain its
significance.
4LEARNING OBJECTIVES
After studying this chapter, you should be able
to
- 8. Compute the degree of operating leverage at a
particular level of sales and explain how the
degree of operating leverage can be used to
predict changes to net income. - 9. Compute the break-even point for a multiple
product company and explain the effects of shifts
in the sales mix on contribution margin and the
break-even point. - 10. (Appendix 6A) Understand cost-volume-profit
with uncertainty.
5The Basics of Cost-Volume-Profit (CVP) Analysis
Contribution Margin (CM) is the amount remaining
from sales revenue after variable expenses have
been deducted.
6The Basics of Cost-Volume-Profit (CVP) Analysis
CM is used to cover fixed expenses.
7The Basics of Cost-Volume-Profit (CVP) Analysis
After covering fixed costs, any remaining CM
contributes to income.
8The Contribution Approach
- For each additional unit Wind sells, 200 more
in contribution margin will help to cover fixed
expenses and profit.
9The Contribution Approach
- Each month Wind must generate at least 80,000 in
total CM to break even.
10The Contribution Approach
- If Wind sells 400 units in a month, it will be
operating at the break-even point.
11The Contribution Approach
- If Wind sells one additional unit (401
bikes), net income will increase by 200.
12The Contribution Approach
- The break-even point can be defined either as
- The point where total sales revenue equals total
expenses (variable and fixed). - The point where total contribution margin equals
total fixed expenses.
13Contribution Margin Ratio
- The contribution margin ratio isFor Wind
Bicycle Co. the ratio is
14Contribution Margin Ratio
- At Wind, each 1.00 increase in sales revenue
results in a total contribution margin increase
of 40. - If sales increase by 50,000, what will be the
increase in total contribution margin?
15Contribution Margin Ratio
A 50,000 increase in sales revenue
16Contribution Margin Ratio
A 50,000 increase in sales revenue results in a
20,000 increase in CM or (50,000 40
20,000)
17Changes in Fixed Costs and Sales Volume
- Wind is currently selling 500 bikes per month.
The companys sales manager believes that an
increase of 10,000 in the monthly advertising
budget would increase bike sales to 540 units. - Should we authorize the requested increase in the
advertising budget?
18Changes in Fixed Costs and Sales Volume
80,000 10,000 advertising 90,000
Sales increased by 20,000, but net income
decreased by 2,000.
19Changes in Fixed Costs and Sales Volume
20APPLICATIONS OF CVP
- Consider the following basic data
- Per unit Percent
- Sales Price 250 100
- Less Variable cost 150 60
- Contribution margin 100 40
- Fixed costs total 35,000
21APPLICATIONS
- Current sales are 100,000. Sales manager feels
10,000 increase in sales budget will provide
30,000 increase in sales. Should the budget be
changed? - Incremental CM approach
- 30,000 x 40 CM ratio 12,000
- Additional advertising expense 10,000
- Increase in net income 2,000
YES
22APPLICATIONS
- Management is considering increasing quality of
speakers at an additional cost of 10 per
speaker. Plan to sell 80 more units. Should
management increase quality? - Expected total CM
- (480 speakers x90) 43,200
- Present total CM
- (400 speakers x100) 40,000
- Increase in total contribution margin 3,200
(and net income)
YES
23APPLICATIONS
- Management advises that if selling price dropped
20 per speaker and advertising increased by
15,000/month, sales would increase 50. Good
idea? - Expected total CM
- (400x150x80) 48,000
- Present total CM (400x100) 40,000
- Incremental CM 8,000
- Additional advertising cost 15,000
- Reduction in net income (7,000)
NO
24APPLICATIONS
- A plan to switch sales people from flat salary
(6,000 per month) to a sales commission of 15
per speaker could increase sales by 15. Good
idea? - Expected total CM (400x115x85) 39,100
- Current total CM (400x100) 40,000
- Decrease in total CM (900)
- Salaries avoided if commission paid 6,000
- Increase in net income 5,100
YES
25APPLICATIONS
- A wholesaler is willing to buy 150 speakers if we
will give him a discount off our price. The sale
will not disturb regular sales and will not
change fixed costs. We want to make 3,000 on
this sale. What price should we quote? - Variable cost per speaker 150
- Desired profit on order (3,000/150) 20
- Quoted price per speaker 170
26Break-Even Analysis
- Break-even analysis can be approached in two
ways - Equation method
- Contribution margin method.
27Equation Method
Profits Sales (Variable expenses Fixed
expenses)
OR
Sales Variable expenses Fixed expenses
Profits
At the break-even point profits equal zero.
28Equation Method
- Here is the information from Wind Bicycle Co.
29Equation Method
- We calculate the break-even point as follows
Sales Variable expenses Fixed expenses
Profits
500Q 300Q 80,000 0 Where Q
Number of bikes sold 500 Unit sales
price 300 Unit variable expenses 80,000
Total fixed expenses
30Equation Method
- We calculate the break-even point as follows
Sales Variable expenses Fixed expenses
Profits
500Q 300Q 80,000 0 200Q 80,000
Q 400 bikes
31Equation Method
- We can also use the following equation to compute
the break-even point in sales dollars.
Sales Variable expenses Fixed expenses
Profits
X 0.60X 80,000 0
Where X Total sales dollars 0.60
Variable expenses as a percentage
of sales 80,000 Total fixed expenses
32Equation Method
- We can also use the following equation to compute
the break-even point in sales dollars.
Sales Variable expenses Fixed expenses
Profits
X 0.60X 80,000 0
0.40X 80,000 X 200,000
33Contribution Margin Method
- The contribution margin method is a variation of
the equation method.
34CVP Relationships in Graphic Form
- Viewing CVP relationships in a graph gives
managers a perspective that can be obtained in no
other way. Consider the following information for
Wind Co.
35CVP Graph
Total Expenses
Dollars
Fixed expenses
Units
36CVP Graph
Total Sales
Dollars
Units
37CVP Graph
Profit Area
Dollars
Break-even point
Loss Area
Units
38Target Profit Analysis
- Suppose Wind Co. wants to know how many bikes
must be sold to earn a profit of 100,000. - We can use our CVP formula to determine the sales
volume needed to achieve a target net profit
figure.
39The CVP Equation
Sales Variable expenses Fixed expenses
Profits
500Q 300Q 80,000 100,000 200Q
180,000 Q 900 bikes
40The Contribution Margin Approach
- We can determine the number of bikes that must
be sold to earn a profit of 100,000 using the
contribution margin approach.
41The Margin of Safety
- Excess of budgeted (or actual) sales over the
break-even volume of sales. The amount by which
sales can drop before losses begin to be incurred.
Margin of safety Total sales - Break-even
sales
Lets calculate the margin of safety for Wind.
42The Margin of Safety
- Wind has a break-even point of 200,000. If
actual sales are 250,000, the margin of safety
is 50,000 or 100 bikes.
43The Margin of Safety
- The margin of safety can be expressed as 20
percent of sales.(50,000 250,000)
44Operating Leverage
- A measure of how sensitive net income is to
percentage changes in sales. - With high leverage, a small percentage increase
in sales can produce a much larger percentage
increase in net income.
45Operating Leverage
46Operating Leverage
- With a measure of operating leverage of 5, if
Wind increases its sales by 10, net income
would increase by 50.
Heres the proof!
47Operating Leverage
10 increase in sales from 250,000 to 275,000 .
. .
. . . results in a 50 increase in income from
20,000 to 30,000.
48The Concept of Sales Mix
- Sales mix is the relative proportions in which a
companys products are sold. - Different products have different selling prices,
cost structures, and contribution margins. - Lets assume Wind sells bikes and carts and see
how we deal with break-even analysis.
49The Concept of Sales Mix
- Wind Bicycle Co. provides us with the following
information
265,000 550,000
48 (rounded)
Break-even point in sales dollars
170,000 0.48
354,167 (rounded)
50Assumptions of CVP Analysis
- Selling price is constant throughout the entire
relevant range. - Costs are linear throughout the entire relevant
range. - In multi-product companies, the sales mix is
constant. - In manufacturing companies, inventories do not
change (units produced units sold).
51Cost-Volume-Profitwith uncertainty
Appendix6A
52CVP with uncertainty
- Use a decision tree to simplify calculations
- The decision tree is used to calculate profits
under various alternatives - A second decision tree can be used to calculate
the probabilities of the various scenarios to
further determine a reasonable estimate of profit - A computer can be used to save time
53End of Chapter 6