COST-VOLUME-PROFIT ANALYSIS A Managerial Planning Tool

COST-VOLUME-PROFIT Traditional Format Total Revenue Total $ Total Costs Breakeven Point Total Variable Costs Total Fixed Costs Level of Activity

CVP ANALYSIS Advantages Assists in establishing prices of products. Assists in analyzing the impact that volume has on short-term profits. Assists in focusing on the impact that changes in costs (variable and fixed) have on profits. Assists in analyzing how the mix of products affects profits.

CVP ANALYSIS Additional Items Breakeven considerations Target income goals This traditional technique is still a powerful element within management accounting: * Superb short-term planning and analytical tool * Places emphasis on contribution margin of products/services * Effective when coupled with “sensitivity analysis” In today’s world, the name should be changed to CAP analysis (Cost-Activity-Profit) Knowledge of the assumptions is essential to use of this technique

LIMITATIONS OF CVP ANALYSIS Requires accurate knowledge of revenue and cost amounts and behavior patterns Identification of fixed and variable components Linear revenue and cost functions Integration of concept of “relevant range” No change in inventories Constant sales mix

Three Methods of Using the CVP Model Operating Income Approach Contribution Approach Graphical Approach

CVP Definitions Contribution margin Contribution margin ratio Revenue – Variable costs Contribution margin ratio Revenue *These items may be computed either in total or per unit

A CVP Example Assume the following: Total Per unit %of Sales Sales (400 Microwaves) $200,000 $500 100% Less: Variable Expenses 120,000 300 60 Contribution Margin $ 80,000 $200 40% Less Fixed Expenses 70,000 Net Income $10,000 1. What is the break-even point? 2. How much sales-revenue must be generated to earn a before-tax profit $30,000? 3. How much sales-revenue must be generated to earn an after-tax profit of $30,000 and a 40% marginal tax rate?

The Operating Income Approach for Breakeven Point Sales - Variable costs - Fixed Costs = Net Income Sales-Revenue Method: 100%(Sales)- 60%(Sales) - $70,000 =0 (at BEP) .4 (Sales) = $70,000 Sales = $175,000 Units-Sold Method: Let x = Number of microwaves at the break-even point $500(x) - $300(x) - $70,000 = 0 (at BEP) $200 (x) = $70,000 x = 350 microwaves

The Contribution Approach for Breakeven Point Sales-Revenue Method: BEP (Revenue $) = (Fixed Costs + Net Income)/Contribution Ratio = $70,000 + 0/.40 = $175,000 Units-Sold Method: BEP (Revenue Units) = (Fixed Costs + Net Income)/Contribution per microwave = $70,000 + 0/$200 per microwave = 350 units

The Operating Income Approach for Targeted Pre-tax Income Sales - Variable costs - Fixed Costs = Net Income Sales-Revenue Method: 100%(Sales)- 60%(Sales) - $70,000 = $30,000 .4 (Sales) = $100,000 Sales = $250,000 Units-Sold Method: Let x = Number of microwaves at the break-even point $500(x) - $300(x) - $70,000 = $30,000 $200 (x) = $100,000 x = 500 microwaves

C-V-P and Targeted After-Tax Profits Sales - Variable costs - Fixed Costs = Net Income/ (1-tax rate) Sales-Revenue Method: 100%(Sales)- 60%(Sales) - $70,000 = $30,000/(1-.4) .4 (Sales) = $120,000 Sales = $300,000 Units-Sold Method: Let x = Number of microwaves at the break-even point $500(x) - $300(x) - $70,000 = $30,000/(1-.4) $200 (x) = $120,000 x = 600 microwaves

COST-VOLUME-PROFIT Traditional Format Total Revenue Total $ Total Costs Breakeven Point Total Variable Costs Total Fixed Costs Level of Activity

COST-PROFIT-VOLUME Contribution Margin Format Total Revenue Total Costs Total $ Breakeven Point Total Fixed Costs Total Variable Costs Contribution Margin Level of Activity

A Multiple-Product Example Assume the following: Regular Deluxe Total Percent Unit of Sales 400 200 600 ---- Sales Price per Unit $500 $750 ---- ---- Sales Revenue $200,000 $150,000 $350,000 100.0% Less: Variable Expenses 120,000 60,000 180,000 51.4 Contribution Margin $ 80,000 $ 90,000 $170,000 48.6% Less Fixed Expenses 130,000 Net Income $ 40,000 1. What is the break-even point? 2. How much sales-revenue of each product must be generated to earn a before-tax profit $50,000?