2. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 1 Cost-Volume-Profit Analysis Chapter 3

3. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 2 Learning Objective 1 Understand the assumptions underlying cost-volume-profit (CVP) analysis.

4. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 3 Cost-Volume-Profit Assumptions and Terminology 1. Changes in the level of revenues and costs arise only because of changes in the number of product (or service) units produced and sold. 2. Total costs can be divided into a fixed component and a component that is variable with respect to the level of output.

5. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 4 Cost-Volume-Profit Assumptions and Terminology 3. When graphed, the behavior of total revenues and total costs is linear (straight-line) in relation to output units within the relevant range (and time period). 4. The unit selling price, unit variable costs, and fixed costs are known and constant.

6. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 5 Cost-Volume-Profit Assumptions and Terminology 5. The analysis either covers a single product or assumes that the sales mix when multiple products are sold will remain constant as the level of total units sold changes. 6. All revenues and costs can be added and compared without taking into account the time value of money.

7. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 6 Cost-Volume-Profit Assumptions and Terminology Operating income = Total revenues from operations – Cost of goods sold and operating costs (excluding income taxes) Net income = Operating income – Income taxes

8. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 7 Learning Objective 2 Explain the features of CVP analysis.

9. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 8 Essentials of Cost-Volume-Profit (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.

10. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 9 Essentials of Cost-Volume-Profit (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)

11. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 10 Essentials of Cost-Volume-Profit (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

12. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 11 Essentials of Cost-Volume-Profit (CVP) Analysis Example Contribution margin percentage (contribution margin ratio) is the contribution margin per unit divided by the selling price. What is the contribution margin percentage? $28 ÷ $70 = 40%

13. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 12 Essentials of Cost-Volume-Profit (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.

14. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 13 Learning Objective 3 Determine the breakeven point and output level needed to achieve a target operating income using the equation, contribution margin, and graph methods.

15. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 14 Breakeven Point Sales Variable expenses Fixed expenses – = Total revenues = Total costs

16. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 15 Abbreviations SP = Selling price VCU = Variable cost per unit CMU = Contribution margin per unit CM% = Contribution margin percentage FC = Fixed costs

17. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 16 Abbreviations Q = Quantity of output units sold (and manufactured) OI = Operating income TOI = Target operating income TNI = Target net income

18. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 17 Equation Method $70Q – $42Q – $84,000 = 0 $28Q = $84,000 Q = $84,000 ÷ $28 = 3,000 units Let Q = number of units to be sold to break even (Selling price × Quantity sold) – (Variable unit cost × Quantity sold) – Fixed costs = Operating income

19. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 18 Contribution Margin Method $84,000 ÷ $28 = 3,000 units $84,000 ÷ 40% = $210,000

20. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 19 Graph Method Revenue Total costs Breakeven Fixed costs

21. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 20 Target Operating Income (Fixed costs + Target operating income) divided either by Contribution margin percentage or Contribution margin per unit

22. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 21 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

23. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 22 Learning Objective 4 Understand how income taxes affect CVP analysis.

24. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 23 Target Net Income and 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

25. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 24 Target Net Income and 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

26. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 25 Target Net Income and 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

27. ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 26 Learning Objective 5 Explain CVP analysis in decision making and how sensitivity analysis helps managers cope with uncertainty.