1. 21 - 1 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 21 Cost-Volume-Profit Analysis

2. 21 - 2 Cost-volume-profit analysis is used to answer questions such as: –What sales volume is needed to earn a target income? –What is the change in income if selling prices decline and sales volume increases? –How much does income increase if we install a new machine to reduce labor costs? –What is the income effect if we change the sales mix of our products or services? Identifying Cost Behavior

3. 21 - 3 Fixed Costs Total fixed costs remain constant as activity increases. remain constant as activity increases. Number of Local Calls Monthly Basic Telephone Bill Cost per call declines as activity increases. Number of Local Calls Monthly Basic Telephone Bill per Local Call C 1

4. 21 - 4 Variable Costs Total variable costs increase as activity increases. Total variable costs increase as activity increases. Minutes Talked Total Costs Cost per Minute Minutes Talked Cost per Minute is constant as increases. Cost per Minute is constant as activity increases. C 1

5. 21 - 5 Mixed Costs Mixed costs contain a fixed portion that is incurred even when the facility is unused, and a variable portion that increases with usage. Utilities typically behave in this manner. Fixed Monthly Utility Charge Variable Cost per KW Activity (Kilowatt Hours) Total Utility Cost Total mixed cost C 1

6. 21 - 6 Step-Wise Costs Total cost increases to a new higher cost for the next higher range of activity, but remains constant within a range of activity. C 1

7. 21 - 7 Curvilinear Costs Costs that increase when activity increases, but in a nonlinear manner. C 1

8. 21 - 8 Measuring Cost Behavior The objective is to classify all costs as either fixed or variable. We will look at three methods: 1.Scatter diagrams. 2.The high-low method. 3.Least–squares regression. A scatter diagram is a plot of cost data points on a graph. It is almost always helpful to plot cost data to be able to observe a visual picture of the relationship between cost and activity. P 1

9. 21 - 9 0 1 2 3 4 5 6 * Total Cost in 1,000’s of Dollars 10 20 0 * * * * * * * * * Activity, 1,000’s of Units Produced Estimated fixed cost = 10,000 Draw a line through the plotted data points so that about equal numbers of points fall above and below the line. Scatter Diagrams P 1

10. 21 - 10 Vertical distance is the change in cost. Horizontal distance is the change in activity. Unit Variable Cost = Slope = Δ in cost Δ in units 0 1 2 3 4 5 6 * Total Cost in 1,000’s of Dollars 10 20 0 * * * * * * * * * Activity, 1,000’s of Units Produced Scatter Diagrams P 1

11. 21 - 11 The following relationships between units produced and total cost are observed: Using these two levels of activity, compute:  the variable cost per unit.  the total fixed cost. The High-Low Method P 1

12. 21 - 12 The High-Low Method Total cost = $17,525 + $0.17 per unit produced P 1  Variable cost per unit is determined as follows:  Fixed costs are determined as follows:

13. 21 - 13 The objective of the cost analysis remains the same: determination of total fixed cost and the variable unit cost. Least-Squares Regression Least-squares regression is usually covered in advanced cost accounting courses. It is commonly used with spreadsheet programs or calculators. P 1

14. 21 - 14 Using Break-Even Analysis The break-even point (expressed in units of product or dollars of sales) is the unique sales level at which a company earns neither a profit nor incurs a loss. A 1

15. 21 - 15 Contribution margin is the amount by which revenue exceeds the variable costs of producing the revenue. Contribution Margin and its Measures Total contribution margin is $60,000 and the contribution margin per unit sold is $30. A 1

16. 21 - 16 Contribution Margin and its Measures Contribution margin ratio Contribution margin per unit Sales price per unit = Contribution margin ratio = $30 per unit $100 per unit = 30% A 1

17. 21 - 17 How much contribution margin must Rydell Company have to cover its fixed costs (break-even)? Answer: $24,000 Computing the Break-Even Point How many units must Rydell sell to cover its fixed costs (break-even)? Answer: $24,000 ÷ $30 per unit = 800 units P 2

18. 21 - 18 We have just seen one of the basic CVP relationships – the break-even computation. Computing the Break-Even Point Break-even point in units = Fixed costs Contribution margin per unit P 2 Unit sales price less unit variable cost ($30 in previous example)

19. 21 - 19 The break-even formula may also be expressed in sales dollars. Unit contribution margin Unit sales price Break-even point in dollars = Fixed costs Contribution margin ratio P 2 Computing the Break-Even Point

20. 21 - 20 Preparing a CVP Chart P 3

21. 21 - 21  A limited range of activity called the relevant range, where CVP relationships are linear.  Unit selling price remains constant.  Unit variable costs remain constant.  Total fixed costs remain constant.  Production = sales (no inventory changes). Making Assumptions in Cost-Volume-Profit Analysis P 3

22. 21 - 22 Working with Changes in Estimates What happens to the break-even point if management can increase the sales price to $105, with no changes in fixed or variable costs? Break-even point in units = Fixed costs Contribution margin per unit Break-even point in units = $24,000 $105 – $70 = 686 units P 3

23. 21 - 23 Income (pretax) = Sales – Variable costs – Fixed costs Computing Income from Sales and Costs Rydell expects to sell 1,500 units at $100 each next month. Fixed costs are $24,000 per month and the unit variable cost is $70. What amount of income should Rydell expect? Income (pretax) = Sales – Variable costs – Fixed costs = [1,500 units × $100] – [1,500 units × $70] – $24,000 = $21,000 C 2

24. 21 - 24 Computing Sales for a Target Income Break-even formulas may be adjusted to show the sales volume needed to earn any amount of income. Unit sales = Fixed costs + Target pretax income Contribution margin per unit Dollar sales = Fixed costs + Target pretax income Contribution margin ratio C 2

25. 21 - 25 Before-tax income = Target net income 1 - tax rate Computing Sales (Dollars) for a Target Net Income To convert target net income to before-tax income, use the following formula: C 2

26. 21 - 26 Computing Sales (Dollars) for a Target Net Income Rydell has a monthly target net income of $9,000. The unit selling price is $100. Monthly fixed costs are $24,000, the unit variable cost is $70, and the tax rate is 25 percent. What is Rydell’s target pretax income? Pretax income = Target net income 1 - tax rate Pretax income = = $12,000 $9,000 1 - 0.25 C 2

27. 21 - 27 Rydell has a monthly target after-tax income of $9,000. The unit selling price is $100. Monthly fixed costs are $24,000, the unit variable cost is $70, and the tax rate is 25 percent. Let’s compute the sales revenue that Rydell will need to earn $12,000 of pretax income? Dollar sales = Fixed costs + Target pretax income Contribution margin ratio Dollar sales = = $120,000 $24,000 + $12,000 30% C 2 Computing Sales (Dollars) for a Target Net Income

28. 21 - 28 Contribution margin per unit Unit sales = Fixed costs + Target pretax income Unit sales = = 1,200 units $24,000 + $12,000 $30 per unit Computing Sales (Units) for a Target Net Income The formula for computing dollar sales may be used to compute unit sales by substituting contribution per unit in the denominator. C 2

29. 21 - 29 Computing the Margin of Safety Margin of safety is the amount by which sales can drop before the company incurs a loss. Margin of safety may be expressed as a percentage of expected sales. Margin of safety Expected sales - Break-even sales percentage Expected sales = If Rydell’s sales are $100,000 and break-even sales are $80,000, what is the margin of safety percentage? C 2 Margin of safety $100,000 - $80,000 percentage $100,000 = = 20%

30. 21 - 30 Rydell Company is considering buying a new machine that would increase monthly fixed costs from $24,000 to $30,000, but decrease unit variable costs from $70 to $60. The $100 per unit selling price would remain unchanged. What is the new break-even point in dollars? Using Sensitivity Analysis Revised Break-even point in dollars Revised fixed costs Revised contribution margin ratio Revised Break-even point in dollars $30,000 40% = $75,000= = C 2

31. 21 - 31 The CVP formulas can be modified for use when a company sells more than one product.  The unit contribution margin is replaced with the contribution margin for a composite unit.  A composite unit is composed of specific numbers of each product in proportion to the product sales mix.  Sales mix is the ratio of the volumes of the various products. Computing a Multiproduct Break-Even Point P 4

32. 21 - 32 The resulting break-even formula for composite unit sales is: Break-even point in composite units Fixed costs Contribution margin per composite unit = Consider the following example: Continue Computing a Multiproduct Break-Even Point P 4

33. 21 - 33 Hair-Today offers three cuts as shown below. Annual fixed costs are $192,000. Compute the break-even point in composite units and in number of units for each haircut at the given sales mix. A 4:2:1 sales mix means that if there are 500 budget cuts, then there will be 1,000 ultra cuts, and 2,000 basic cuts. Computing a Multiproduct Break-Even Point P 4

34. 21 - 34 Contribution margin per composite unit Step 1: Compute contribution margin per composite unit. Computing a Multiproduct Break-Even Point P 4

35. 21 - 35 Break-even point in composite units Fixed costs Contribution margin per composite unit = Step 2: Compute break-even point in composite units. Break-even point in composite units $192,000 $64.00 per composite unit = Break-even point in composite units = 3,000 composite units Computing a Multiproduct Break-Even Point P 4

36. 21 - 36 Step 3: Determine the number of each haircut that must be sold to break-even. Computing a Multiproduct Break-Even Point P 4

37. 21 - 37 Step 4: Verify the results. Multiproduct Break-Even Income Statement P 4

38. 21 - 38 Global View Over 90 percent of German companies surveyed report their cost accounting systems focus on contribution margin. This focus helps German companies like Volkswagen control costs and plan their production levels.

39. 21 - 39 A measure of the extent to which fixed costs are being used in an organization. A measure of how a percentage change in sales will affect profits. Contribution margin Pretax income = Degree of operating leverage Degree of Operating Leverage A 2

40. 21 - 40 $36,000 $12,000 = 3.0 Contribution margin Net income = Degree of operating leverage = If Rydell increases sales by 10 percent, what will the percentage increase in income be? Operating Leverage A 2

41. 21 - 41 Appendix 21A: Using Excel to Estimate Least-Squares Regression =INTERCEPT(C2:C13, B2:B13) =SLOPE(C2:C13, B2:B13)

42. 21 - 42 End of Chapter 21