Chapter 15 Cost volume profit analysis

Cost volume profit (CVP) analysis §Can be used to determine the effects of changes in an organisation’s sales volume on its costs, revenue and profit

The break-even point §the volume of sales where the total revenues and expenses are equal, and the operation breaks even

Terminology §Contribution margin (or variable costing) statement l highlights the variable and fixed costs of a business §Total contribution margin l the total sales revenue minus total variable costs l the amount available to cover fixed costs and then contribute to profits Cont.

Terminology §Unit contribution margin l the difference between the sales price per unit and variable cost per unit §Contribution margin ratio l equal to the unit contribution margin divided by the unit sales price l the proportion of each sales dollar available to cover fixed costs and earn a profit Cont.

Terminology §Contribution margin percentage l the contribution margin ratio multiplied by 100 l the percentage of each sales dollar available to cover fixed costs and earn a profit

Cost volume profit (CVP) graph §Shows how costs, revenue and profits change as sales volume changes §five steps l draw the fixed expense line l draw the total expense line l draw the total revenue line l break-even point - where the total revenue and total expense lines intersect

Profit volume (PV) graph §shows the total amount of profit or loss at different sales volumes

Target net profit §A desired profit level determined by management §Can be used within the break-even formula

Using CVP analysis for management decision making §Common applications include l safety margin l changes in fixed expenses l changes in the unit contribution margin l multiple changes in key variables

Safety margin §Difference between the budgeted sales revenue and the break-even sales revenue §Gives a feel for how close projected operations are to the break-even point

Changes in fixed expenses §When estimates of fixed costs are revised, the break-even point will change l percentage change in fixed expenses will lead to similar increase in the break-even point (in units or dollars) §Different fixed costs may apply to different levels of sales volume l more than one break-even point

Changes in the unit contribution margin §Change in unit variable expenses l changes the unit contribution margin l a new break-even point l an increase in unit variable expenses will increase the break-even point Cont.

Changes in the unit contribution margin §Change in sales price l changes the unit contribution margin l a new break-even point l an increase in unit price will lower the break- even point

Multiple changes in key variables §May involve l increasing unit prices l undertaking an advertising campaign l hiring a new storage facility §An incremental approach l focuses on the difference in the total contribution margin, fixed expenses and profits under the two alternatives

CVP analysis with multiple products §Sales mix l reflects the relative proportions of each type of product sold by the organisation §Weighted average unit contribution margin l the average of the products’ unit contribution margins, weighted by the sales mix

Effects of income taxes

Assumptions underlying CVP analysis §The behaviour of total revenue is linear §The behaviour of total costs is linear over a relevant range l costs can be categorised as fixed, variable or semivariable l labour productivity, production technology and market conditions do not change l there are no capacity changes during the period under consideration Cont.

Assumptions underlying CVP analysis §For both variable and fixed costs, sales volume is the only cost driver §The sales mix remains constant over the relevant range §In manufacturing firms, levels of inventory at the beginning and end of the period are the same

Treating CVP analysis with caution §CVP analysis is merely a simplified model §The usefulness of CVP analysis may be greater in less complex smaller firms §For larger firms, CVP analysis can be valuable as a decision tool for the planning stages of new projects and ventures

Spreadsheets and computerised planning models §Sensitivity analysis l examines how an outcome may change due to variations in the predicted data §Goal seeking approaches l the analyst specifies the outcome, so that software can specify the necessary inputs §What-if analysis l the analyst specifies changes in assumptions to examine the effect of these changes on outcomes

An activity-based approach to CVP analysis §ABC categorises activities as facility, product, batch or unit costs l Facility, product and batch activities are non- volume activity costs

Limiting assumption of using activity-based costs §Batch costs are based on likely production levels §New planned production levels lead to changes in the number of production batches, and changes in total non-volume activity costs --> new break-even or target profit volume

Exhibit 15.1