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**Cost-Volume-Profit Relationships**

Chapter 4 Cost-Volume-Profit Relationships Chapter 4: Cost-volume-profit relationships. Cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and profit by focusing their attention on the interactions among the prices of products, volume of activity, per unit variable costs, total fixed costs, and mix of products sold. It is a vital tool used in many business decisions such as deciding what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

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**Basics of Cost-Volume-Profit Analysis**

The contribution income statement is helpful to managers in judging the impact on profits of changes in selling price, cost, or volume. The emphasis is on cost behavior. The contribution income statement is helpful to managers in judging the impact on profits of changes in selling price, cost, or volume. For example, let's look at a hypothetical contribution income statement for Racing Bicycle Company (RBC). Notice the emphasis on cost behavior. Variable costs are separate from fixed costs. The contribution margin is defined as the amount remaining from sales revenue after variable expenses have been deducted. Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted.

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**CVP Relationships in Equation Form**

When a company has only one product we can further refine this equation as shown on this slide. Profit = (Sales – Variable expenses) – Fixed expenses Part I If the company sells a single product, like Racing Bicycle Company, we can express the sales and variable expenses as shown in the blue and brown boxes. Sales are equal to the quantity sold (Q) times the selling price per unit sold (P), and variable expenses are equal to the quantity sold (Q) times the variable expenses per unit (V). Part II For the single product company we can refine the equation as shown on the screen. We can complete the calculations shown in the previous slides using the contribution income statement approach using this equation. Let’s see how we do this. Profit = (P × Q – V × Q) – Fixed expenses

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**Contribution Margin Ratio (CM Ratio)**

The CM ratio is calculated by dividing the total contribution margin by total sales. The contribution margin ratio is calculated by dividing the total contribution margin by total sales. In the case of Racing Bicycle, the ratio is 40%. Thus, each $1.00 increase in sales results in a total contribution margin increase of 40¢. $100,000 ÷ $250,000 = 40%

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**The Variable Expense Ratio**

The variable expense ratio is the ratio of variable expenses to sales. It can be computed by dividing the total variable expenses by the total sales, or in a single product analysis, it can be computed by dividing the variable expenses per unit by the unit selling price. The variable expense ratio is the ratio of variable expenses to sales. It can be computed by dividing the total variable expenses by the total sales, or in a single product analysis, it can be computed by dividing the variable expenses per unit by the unit selling price. At Racing Bicycle the variable expense ratio is 60%.

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**Target Profit Analysis**

We can compute the number of units that must be sold to attain a target profit using either: Equation method Formula method. We can compute the number of units that must be sold to attain a target profit using either the equation method or the formula method.

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**Equation Method Profit = Unit CM × Q – Fixed expenses**

Our goal is to solve for the unknown “Q” which represents the quantity of units that must be sold to attain the target profit. The equation method is based on the contribution approach income statement. The equation we have used is that profit equals unit CM times units sold, Q, less fixed expenses. Our goal is to solve for the unknown “Q” which represents the quantity of units that must be sold to attain the target profit.

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**The formula uses the following equation.**

The Formula Method The formula uses the following equation. Target profit + Fixed expenses CM per unit = Unit sales to attain the target profit Target profit expressed in units sold. For this equation we divide the sum of the desired target profit plus total fixed expenses by the contribution margin per unit.

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**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 determining their organization’s cost structure. A company’s cost structure refers to the relative proportion of fixed and variable expenses. Some companies have high fixed expenses relative to variable expenses. Do you remember our discussion of utility companies? Because of the heavy investment in property, plant and equipment, many utility companies have a high proportion of fixed costs.

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**Operating Leverage = Contribution margin Net operating income**

Operating leverage is a measure of how sensitive net operating income is to percentage changes in sales. It is a measure, at any given level of sales, of how a percentage change in sales volume will affect profits. Contribution margin Net operating income Degree of operating leverage = Operating leverage is a measure of how sensitive net operating income is to percentage changes in sales. The degree of operating leverage is a measure, at any given level of sales, of how a percentage change in sales volume will affect profits. It is computed by dividing contribution margin by net operating income. Let’s look at Racing Bicycle.

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End of Chapter 4 End of Chapter 4

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