1. Cost-Volume-Profit Relationships UAA – ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee

2. Dr. Fred BarbeeACCT 202 - UAA - Fall 20042 Introduction We have learned... –How to identify costs as fixed, variable, and mixed; –How each of these behave when changes take place; and –How to separate them into their component parts.

3. Dr. Fred BarbeeACCT 202 - UAA - Fall 20043 Introduction Understanding these relationships help managers to; –Predict future conditions (planning); and –Explain, evaluate, and act on past results (control)

4. Dr. Fred BarbeeACCT 202 - UAA - Fall 20044 Introduction Today we will focus on gaining an understanding of how... –Costs –Volume, and –Profits Interact

5. Dr. Fred BarbeeACCT 202 - UAA - Fall 20045 Cost-Volume-Profit (CVP) CVP is the systematic examination of the relationships among... –Selling prices, –Volume of Sales and Production –Cost, –Expenses, and –Profits

6. Output Sales Price Variable Costs Fixed Costs Total Revenues Total Cost Operating Income Total Revenue Total Cost Operating Income What happens here? As changes occur here. Graphically 4 Output Sales Price Variable Costs Fixed Costs

7. Dr. Fred BarbeeACCT 202 - UAA - Fall 20047 CVP - For-Profit Firms How many photocopies must the College Avenue Copy Shop produce to earn a profit of $20,000? At what sales volume will Burger King’s total costs and total revenues equal?

8. Dr. Fred BarbeeACCT 202 - UAA - Fall 20048 CVP - For-Profit Firms What will happen to profits in Joe’s Diner if... –There is a 20% increase in the cost of food; and –A 10% increase in the selling price of meals?

9. Dr. Fred BarbeeACCT 202 - UAA - Fall 20049 CVP - Not-For-Profit Firms How many meals can the Salvation Army serve with an annual budget of $150,000? How many tickets must be sold for the benefit concert to raise $15,000?

10. Dr. Fred BarbeeACCT 202 - UAA - Fall 200410 CVP is Useful in... Choice of product lines Pricing of products Developing marketing strategies Utilization of productive facilities

11. Dr. Fred BarbeeACCT 202 - UAA - Fall 200411 Traditional Statement Costs are grouped by functional classifications - such as: –Production, –Selling & Administration With both fixed and variable costs being included in each category.

12. Sales$xxx COGS(xx) Gross Margin$xxx Selling Exp.(xx) Net Income $xxx Admin. Exp(xx) Production FC & VC Selling FC & VC Administrative FC & VC

13. Dr. Fred BarbeeACCT 202 - UAA - Fall 200413 Contribution Format The focus of the contribution format income statement is the contribution margin... Contribution Margin = Net Sales - Variable Costs

14. Dr. Fred BarbeeACCT 202 - UAA - Fall 200414 Contribution Format I/S Groups costs by behavior: –Fixed, and –Variable Rather than into the functional categories of production, marketing and administration.

15. Sales$xxx Variable Costs(xx) Cont. Margin$xxx Fixed Costs(xx) Net Income $xxx

16. Income Statements... Sales$xxx COGS(xx) Gross Margin$xxx Operating Exp(xx) TraditionalContribution Format Net Income $xxx Sales$xxx Variable Costs(xx) Cont. Margin$xxx Fixed Costs(xx) Net Income $xxx

17. Sourdough Alaska, Inc. Sales $900,000 Cost of Sales Direct Materials $100,000 Direct Labor 160,000 Mfg. Overhead 100,000 361,000 VC=$55,000 FC=$45,000 Marketing Costs Variable 18,000 Fixed 82,000 100,000 Admin. Costs (Fixed) $150,000

18. Sourdough Alaska, Inc. Traditional Income Statement For Year Ended December 31, 2002 Sourdough Alaska, Inc. Traditional Income Statement For Year Ended December 31, 2002 Sales $900,000 100% Cost of Sales Direct Materials $100,000 Direct Labor 160,000 Mfg. Overhead 100,000 360,000 40% Gross Margin $540,000 60% Marketing/Admin Costs Marketing Costs $100,000 Administrative Costs 150,000 250,000 Net Income $290,000

19. Dr. Fred BarbeeACCT 202 - UAA - Fall 200419 What if... You were asked to project the effect on net income of: –A 20% increase in sales volume; –With no change in selling prices. How would you go about doing it?

20. Sourdough Alaska, Inc. Contribution Format Income Statement For Year Ended December 31, 2002 Sourdough Alaska, Inc. Contribution Format Income Statement For Year Ended December 31, 2002 Sales $900,000 100% Cost of Sales Direct Materials $100,000 Direct Labor 160,000 Mfg. Overhead 55,000 Variable Mkt. Exp 18,000 $333,000 37% Contribution Martin $567,000 63% Fixed Costs Manufacturing 45,000 Marketing 82,000 Administrative 150,000 277,000 Net Income $290,000

21. Dr. Fred BarbeeACCT 202 - UAA - Fall 200421 NOW... What if... You were asked to project the effect on net income of: –A 20% increase in sales volume; –With no change in selling prices. How would you go about doing it?

22. Sourdough Alaska, Inc. Projected Increase in Net Income For Year Ended December 31, 2002 Sourdough Alaska, Inc. Projected Increase in Net Income For Year Ended December 31, 2002 Sales ($900,000 x 120%) $1,080,000 Contribution Margin 688,400 Projected Net Income 403,400 Less: VC: ($333,000 x 120%) 399,600 Less: Fixed Costs 277,000 Less Original NI Projection 290,000 Projected Increase in Net Income $113,400

23. Dr. Fred BarbeeACCT 202 - UAA - Fall 200423 2 Can be computed two ways: –The equation method –The contribution margin method Breakeven Analysis

24. Dr. Fred BarbeeACCT 202 - UAA - Fall 200424 2 Can be computed in two forms: Breakeven Analysis –Number of units required to break even; or –Sales dollars required to break even.

25. The Equation Method Exhaustion Unlimited – An Illustration

26. Dr. Fred BarbeeACCT 202 - UAA - Fall 200426 Exhaustion Unlimited Exhaustion Unlimited makes and distributes high end exercise equipment. One of their best selling products is an exercise bike – Model IMATRD-1

27. Per BikePercent SP$500100% VC30060% CM$20040% Fixed Costs = $80,000

28. The equation method centers on the contribution approach to the income statement. Sales$xxx Variable Costs(xx) Contribution Margin$xxx Fixed Costs(xx) Net Operating Income$xxx

29. At breakeven profit = 0  The equation becomes:

30. Use our BE Equation; and Let X = BE Point in Bikes Sales = VC + FC $500X = $300X + $80,000 $200X = $80,000 X = 400 Bikes Sales FCVC

31. Use our BE Equation; and Let X = BE Point in Sales $ Sales = VC + FC 1X =.6X + $80,000.4X = $80,000 X = $200,000 Sales FCVC

32. Exhaustion Unlimited Income Statement For Year Ended 12/31/01 Sales (400 x $500)$200,000 VC (400 x $300)120,000 CM$80,000 FC80,000 Net Income$-0-

33. The Unit Contribution Method Exhaustion Unlimited – An Illustration

34. Dr. Fred BarbeeACCT 202 - UAA - Fall 200434 Unit-Contribution Method Is a variation of the equation method. The method may be just a bit more intuitive than the equation method.

35. Dr. Fred BarbeeACCT 202 - UAA - Fall 200435 The approach centers on the idea that each unit sold provides a certain amount of CM that goes toward covering fixed costs. Unit-Contribution Method

36. Dr. Fred BarbeeACCT 202 - UAA - Fall 200436 The Formula... Unit-Contribution Method Fixed Expenses =BEP Unit Contribution Margin

37. Fixed Costs Unit CM BEP in Units

38. Fixed Costs CM % BEP in $

39. Dr. Fred BarbeeACCT 202 - UAA - Fall 200439 Unit Contribution Method Let’s look at a series of income statements that graphically point out the concept of a contribution margin.

40. Exhaustion Unlimited Income Statement 1 Bike2 Bikes400 Bikes401 Bikes Sales$500$1,000$200,000$200,500 VC300600120,000$120,300 CM$200$400$80,000$80,200 FC80,000 NI($79,800)($79,600)$-0-$200

41. Break-Even Analysis Target Net Profit Analysis

42. Dr. Fred BarbeeACCT 202 - UAA - Fall 200442 Target Net Profit Analysis A firm’s targeted NI is the amount of income the firm wishes to make... –Pre-Tax OI; or –After-Tax NI

43. Dr. Fred BarbeeACCT 202 - UAA - Fall 200443 Target Net Profit Analysis Recall the BE formula:

44. Dr. Fred BarbeeACCT 202 - UAA - Fall 200444 Target Net Profit Analysis Using data from Exhaustion Unlimited. Assume the firm wants to make a before-tax profit of $40,000.

45. Per BikePercent SP$500100% VC30060% CM$20040% Fixed Costs = $80,000

46. Use our BE Equation; and Let X = BE Point in Bikes Sales = VC + FC + Profits $500X = $300X + $80,000 + $40,000 $200X = $120,000 X = 600 Bikes Sales FCVC Desired Profit

47. Use our BE Equation; and Let X = BE Point in Sales $ Sales = VC + FC + Profits 1X =.6X + $80,000 + $40,000.4X = $12,000 X = $300,000 Sales FCVC Desired Profit

48. Exhaustion Unlimited Income Statement For Year Ended 12/31/01 Sales (600 x $500)$300,000 VC (600 x $300)180,000 CM$120,000 FC80,000 Net Income$40,000

49. Target Before-Tax Profit Analysis The Unit Contribution Method

50. Dr. Fred BarbeeACCT 202 - UAA - Fall 200450 The Formula... Unit-Contribution Method Fixed Expenses =BEP Unit Contribution Margin Add Targeted Before-Tax OI (TI) to the Fixed Expenses Fixed Expenses +TI =BEP Unit Contribution Margin Add Targeted Before-Tax OI (TI) to the Fixed Expenses

51. Fixed Costs Unit CM BEP in Units Desired BT OI (TI)

52. Fixed Costs CM % BEP in $ Desired BT OI

53. Target Net Profit Analysis What About Taxes?

54.  The equation becomes: Remember this? Profit = Taxes At breakeven profit = 0

55. Dr. Fred BarbeeACCT 202 - UAA - Fall 200455 Tax Effects...

56. Dr. Fred BarbeeACCT 202 - UAA - Fall 200456 Net Income OI = ------------------ (1 – TR) This, then, is our handy-dandy formula to calculate an after- tax net income (ATNI).

57. Dr. Fred BarbeeACCT 202 - UAA - Fall 200457 Target Net Profit Analysis Back to Exhaustion Unlimited Assume management wants $40,000 after taxes Tax Rate = 30%

58. Sales = VC + FC + ATNI SalesFC VC Targeted ATNI

59. Sales = VC + FC + ATNI Bikes

61. Dr. Fred BarbeeACCT 202 - UAA - Fall 200461 Limiting Assumptions CVP assumes a linear revenue and cost function. CVP analysis assumes a relevant range. CVP assumes that production equals sales.

62. Dr. Fred BarbeeACCT 202 - UAA - Fall 200462 Limiting Assumptions Sales mix remains constant. Sales prices and costs are known with certainty.