Copyright © 2007 Prentice-Hall. All rights reserved 1 Cost-Volume-Profit Analysis Chapter 21

Copyright © 2007 Prentice-Hall. All rights reserved 2 Objective 1 Identify how changes in volume affect costs

Copyright © 2007 Prentice-Hall. All rights reserved 3 Cost Behavior How costs change in response to changes in a cost driver Cost driver - any factor whose change makes a difference in a related total cost Volume (units or dollars) - most prominent cost driver in cost-volume-profit (CVP) analysis

Copyright © 2007 Prentice-Hall. All rights reserved 4 Cost Behavior Variable costs - change directly in proportion to changes in volume Fixed costs - remain constant (fixed) for a given time period despite fluctuations in volume Mixed costs - have both fixed and variable components

Copyright © 2007 Prentice-Hall. All rights reserved 5 Total Variable Costs Assume we pay sales commissions of 5% on all sales. The cost of sales commissions increase proportionately with increases in sales

Copyright © 2007 Prentice-Hall. All rights reserved 6 Variable Cost Per Unit Variable costs per unit do not change as activity increases In the previous example, sales persons get $.05 for every dollar of sales. If a sales person has sales of $1,000 or $15,000, she gets $.05 for every dollar

Copyright © 2007 Prentice-Hall. All rights reserved 7 Total Fixed Costs Assume we pay our sales staff a salary of $2,000 per month. If a sales person makes sales of $500, she gets paid $2,000 salary. If she has sales of $100,000, she gets paid $2,000 salary

Copyright © 2007 Prentice-Hall. All rights reserved 8 Mixed Costs A mixed cost has elements of both fixed and variable costs. Assume we pay our sales staff, $2,000 plus 5% commission on each sales dollar

Copyright © 2007 Prentice-Hall. All rights reserved 9 Mixed Costs Variable Fixed

Copyright © 2007 Prentice-Hall. All rights reserved 10 E21-14E21-14 _____ 1. Oil filter _____ 2. Building rent _____ 3. Oil _____ 4. Wages of maintenance worker _____ 5. Television _____ 6. Manager’s salary _____ 7. Cash register _____ 8. Equipment F V V V F F F F

Copyright © 2007 Prentice-Hall. All rights reserved 11 E21-15 a

Copyright © 2007 Prentice-Hall. All rights reserved 12 E21-15 b

Copyright © 2007 Prentice-Hall. All rights reserved 13 E21-15 c

Copyright © 2007 Prentice-Hall. All rights reserved 14 High-Low Method Method to separate mixed costs into variable and fixed components Select the highest level and the lowest level of activity over a period of time In order to do CVP analysis, we have to classify costs as to whether they are fixed or variable. One method of doing this is the high-low method

Copyright © 2007 Prentice-Hall. All rights reserved 15 High-Low Method – E21-16 Step 1: Calculate variable cost/unit = Δ total cost / Δ volume of activity ($4,000-$3,600) ÷ (1, ) $400 ÷ 400 = $1

Copyright © 2007 Prentice-Hall. All rights reserved 16 High-Low Method - E21-16 Step 2: Calculate total fixed costs = Total mixed cost – Total variable cost $4,000 – ($1 * 1,000) = $3,000 or $3,600 – ($1 * 600) = $3,000

Copyright © 2007 Prentice-Hall. All rights reserved 17 High-Low Method – E21-16 Step 3: Create and use an equation to show the behavior of a mixed cost Total mixed cost = $1x + $3,000 = ($1 * 900) + $3,000 = $3,900

Copyright © 2007 Prentice-Hall. All rights reserved 18 Relevant Range Band of volume: Where total fixed costs remain constant and variable cost per unit remains constant Outside the relevant range, the cost either increases or decreases CVP analysis is only valid within a relevant range, which is usually the range that could reasonably be expected for our business

Copyright © 2007 Prentice-Hall. All rights reserved 19 Objective 2 Use CVP analysis to compute breakeven point

Copyright © 2007 Prentice-Hall. All rights reserved 20 AssumptionsAssumptions 1.Expenses can be classified as either variable or fixed 2.The only factor that affects costs is change in volume

Copyright © 2007 Prentice-Hall. All rights reserved 21 Breakeven Point Sales level at which operating income is zero Sales above breakeven result in a profit Sales below breakeven result in a loss

Copyright © 2007 Prentice-Hall. All rights reserved 22 Income Statement Approach Contribution Margin Income Statement Sales - Variable Costs Contribution Margin - Fixed Costs Operating Income This income statement classifies expenses according to behavior Contribution margin is the excess of sales revenue over variable costs that contributes to covering fixed costs and then to providing operating income To compute breakeven point set the equation equal to zero

Copyright © 2007 Prentice-Hall. All rights reserved 23 Contribution Margin Approach Breakeven units sold = Fixed costs + Operating income Contribution margin per unit

Copyright © 2007 Prentice-Hall. All rights reserved 24 Contribution Margin Ratio Contribution margin ÷ Sales revenue Breakeven sales dollars = Fixed costs + Operating income Contribution margin ratio

Copyright © 2007 Prentice-Hall. All rights reserved 25 E Contribution margin ÷ Sales revenue $187,500 ÷ $312,500 = 60%

Copyright © 2007 Prentice-Hall. All rights reserved 26 E Aussie Travel Contribution Margin Income Statement Three Months Ended March 31, 2007 Sales revenue $250,000$360,000 Variable Costs (40%)(100,000)(144,000) Contribution Margin (60%)$150,000$216,000 Fixed Costs(170,000)(170,000) Operating Income$(20,000)$46,000

Copyright © 2007 Prentice-Hall. All rights reserved 27 E Breakeven sales dollars = Fixed costs + Operating income Contribution margin ratio $170,000 + $0.60 $283,333

Copyright © 2007 Prentice-Hall. All rights reserved 28 E21-18E Contribution margin = Sales–Variable costs = $ $0.85 = $ Breakeven units sold = Fixed costs + Operating income Contribution margin per unit ($85,000 + $0) / $0.85 = 100,000 units 100,000 units x $1.70 = $170,000

Copyright © 2007 Prentice-Hall. All rights reserved 29 Objective 3 Use CVP analysis for profit planning and graph relations

Copyright © 2007 Prentice-Hall. All rights reserved 30 Plan Profits Example: The following information is available for Conte Company. Sale price per unit$30 Variable costs per unit21 Total fixed costs$180,000 Target operating income$90,000 How many units must be sold to meet the targeted operating income? Use the same techniques used for breakeven point

Copyright © 2007 Prentice-Hall. All rights reserved 31 Plan Profits Sales – variable costs – fixed costs = operating income $30x – $21x - $180,000 = $90,000 $9x = $270,000 x = 30,000 units

Copyright © 2007 Prentice-Hall. All rights reserved 32 Preparing a CVP Chart Step 1: –Choose a sales volume –Plot point for total sales revenue –Draw sales revenue line from origin

Copyright © 2007 Prentice-Hall. All rights reserved 33 Preparing a CVP Chart

Copyright © 2007 Prentice-Hall. All rights reserved 34 Preparing a CVP Chart Step 2: Draw the fixed cost line

Copyright © 2007 Prentice-Hall. All rights reserved 35 Preparing a CVP Chart

Copyright © 2007 Prentice-Hall. All rights reserved 36 Preparing a CVP Chart Step 3: Draw the total cost line ( fixed plus variable)

Copyright © 2007 Prentice-Hall. All rights reserved 37 Preparing a CVP Chart

Copyright © 2007 Prentice-Hall. All rights reserved 38 Preparing a CVP Chart Step 4: Identify the breakeven point and the areas of operating income and loss

Copyright © 2007 Prentice-Hall. All rights reserved 39 Preparing a CVP Chart Breakeven point Profit Loss

Copyright © 2007 Prentice-Hall. All rights reserved 40 E21-21E21-21 Profit Breakeven point Revenues Total Costs Fixed Costs

Copyright © 2007 Prentice-Hall. All rights reserved 41 Objective 4 Use CVP methods to perform sensitivity analysis

Copyright © 2007 Prentice-Hall. All rights reserved 42 Sensitivity Analysis “What if” analysis What if the sales price changes? What if costs change?

Copyright © 2007 Prentice-Hall. All rights reserved 43 E21-22E21-22 Sale price per student$200 Variable costs per student120 Total fixed costs$50, Contribution margin per unit: $200 – 120 = $80 Breakeven point: $50,000 ÷ $80 = 625 students

Copyright © 2007 Prentice-Hall. All rights reserved 44 E21-22E21-22 Sale price per student$180 Variable costs per student120 Total fixed costs$50, Contribution margin per unit: $180 – 120 = $60 Breakeven point: $50,000 ÷ $60 = 833 students

Copyright © 2007 Prentice-Hall. All rights reserved 45 E21-22E21-22 Sale price per student$200 Variable costs per student110 Total fixed costs$50, Contribution margin per unit: $200 – 110 = $90 Breakeven point: $50,000 ÷ $90 = 556 students

Copyright © 2007 Prentice-Hall. All rights reserved 46 E21-22E21-22 Sale price per student$200 Variable costs per student120 Total fixed costs$40, Contribution margin per unit: $200 – 120 = $80 Breakeven point: $40,000 ÷ $80 = 500 students

Copyright © 2007 Prentice-Hall. All rights reserved 47 Margin of Safety Excess of expected sales over breakeven sales Drop in sales that the company can absorb before incurring a loss

Copyright © 2007 Prentice-Hall. All rights reserved 48 E21-23E21-23 Margin of safety = Expected sales – breakeven sales Expected sales: Sales – variable costs – fixed costs = operating income 1x -.70x - $9,000 = $12,000.30x = $21,000 x = $70,000

Copyright © 2007 Prentice-Hall. All rights reserved 49 E21-23E21-23 Margin of safety = Expected sales – breakeven sales Breakeven sales: Sales – variable costs – fixed costs = operating income 1x -.70x - $9,000 = $0.30x = $9,000 x = $30,000

Copyright © 2007 Prentice-Hall. All rights reserved 50 E21-23E21-23 Margin of safety = Expected sales – breakeven sales = $70,000 - $30,000 = $40,000

Copyright © 2007 Prentice-Hall. All rights reserved 51 Objective 5 Calculate the breakeven point for multiple product lines or services

Copyright © 2007 Prentice-Hall. All rights reserved 52 Multiple Product Break-Even Point – E21-24 Step 1: Calculate weighted-average contribution margin StandardChromeTotal Sale price per unit$54$78 Variable costs per unit3650 Contribution margin per unit$18$28 Sales mix in unitsx 2x 3 Contribution margin$36$84$120 Weighted average contribution Margin per unit ($120 / 5)$24 Use same formulas used earlier, but compute the weighted average contribution margin of all products. Sales mix = Combination of products that make up total sales Multiply each contribution margin per unit times the sales mix and add them together. Divide that number by the total number of units in the sales mix

Copyright © 2007 Prentice-Hall. All rights reserved 53 Multiple Product Break-Even Point – E21-24 Step 2: Calculate the breakeven point in units Fixed costs + Operating income Weighted average contribution margin per unit $12,000 + $0 ÷ $24 = 500 composite units

Copyright © 2007 Prentice-Hall. All rights reserved 54 Multiple Product Break-Even Point – E21-24 Step 3: Calculate the breakeven point in units for each product line Standard: 500 units x 2 = 1,000 Chrome: 500 units x 3 = 1,500 The composite unit consists of 2 standard scooters and 3 chrome scooters. Multiply the breakeven units x sales mix

Copyright © 2007 Prentice-Hall. All rights reserved 55 E21-24E21-24 To earn $6,600 Fixed costs + Operating income Weighted average contribution margin per unit ($12,000 + $6,600) ÷ $24 = 775 composite units Standard: 775 x 2 = 1,550 Chrome: 775 x 3 = 2,325

Copyright © 2007 Prentice-Hall. All rights reserved 56 End of Chapter 21