1. Cost Behavior and Decision Making: Cost, Volume, Profit Analysis
Chapter 6
Cost Behavior and Decision Making: Cost, Volume, Profit Analysis

2. Topics Introduction The Contribution Margin Income Statement
The Contribution Margin and Its Uses

3. Introduction
Cost-Volume-Profit Analysis (CVP) Focuses on the following factors:
The prices of products or services
The volume of products or services produced and sold
The per-unit variable costs
The total fixed costs
The mix of products or services produced

4. The Contribution Margin Income Statement
The Contribution Margin Income Statement is structured by behavior rather than by function.
Sales - All Variable Costs = Contribution Margin
Contribution Margin - All Fixed Costs = Net Income

5. Income Statements TRADITIONAL CONTRIBUTION MARGIN Sales
Less: Cost of Goods Sold
Variable Costs
Fixed Costs
Total Costs of Goods Sold
Gross Profit
Less: S&A Costs
Total S&A Costs
Net Income
$1,000
350
150
$ 500
$ 50
250
$ 300
$ 200
Sales
Less: Variable Costs
Manuf. Costs
S&A Costs
Total Variable Costs
Contribution Margin
Less: Fixed Costs
Total Fixed Costs
Net Income
$1,000
$350 50
$400
$600
$150
250
$200

6. The Contribution Margin Income Statement
Key Concept
The contribution margin income statement is structured to emphasize cost behavior as opposed to cost function.

7. Contribution Margin Per Unit
Sales (100,000 units)
Less: Variable Costs
Contribution Margin
Less: Fixed Costs
Net Income
Total
$200,000
80,000
$120,000
40,000
$80,000
Per Unit
$2.00
.80
$1.20

8. Contribution Margin Per Unit
What if HD Inc. sold one more unit?
Sales (100,001 units)
Less: Variable Costs
Contribution Margin
Less: Fixed Costs
Net Income
Total
$200,002.00
80,000.80
$120,001.20
40,000.00
$80,001.20
Per Unit
$2.00
.80
$1.20

9. Contribution Margin Per Unit
Key Concept
For every unit change in sales, contribution margin will increase or decrease by the contribution margin per unit multiplied by the increase or decrease in sales volume.

10. Contribution Margin Ratio=
Contribution Margin (in $)
Sales (in $)

11. Contribution Margin Ratio
Sales (100,000 units)
Less: Variable Costs
Contribution Margin
Less: Fixed Costs
Net Income
Total
$200,000
80,000
$120,000
40,000
$80,000
Percent
100% 40
60%

12. Contribution Margin Ratio
Key Concept
The contribution margin per unit and the contribution margin ratio will remain constant as long as sales vary in direct proportion with volume.

13. Contribution Margin Ratio
Key Concept
For every dollar change in sales, contribution margin will increase or decrease by the contribution margin ratio multiplied by the increase or decrease in sales dollars.

14. Contribution Margin Ratio
Using either contribution margin per unit or contribution margin ratio, calculate HD Inc.’s net income (loss) when sales are 25,000 units or $50,000.
Answer:
25,000 units x $1.20 cm = $30,000 or $50,000 x 60% = $30,000

15. The Contribution Margin and Its Uses
What would happen if sales increase?
Use the CM to determine the increase of net income. Then consider what must happen before sales increase. Lower sales price? Increase incentives for sales staff? Improve quality of product? Increase advertising budget?

16. What-If Decisions Using CVP
Step 1: Define the Problem
Contribution margin is not sufficient to cover fixed costs.

17. What-If Decisions Using CVP
Step 2: Identify Objectives
1. Increase net income
2. Maintain a high-quality product

18. What-If Decisions Using CVP
Step 3:Identify and analyze available options
1. Reduce variable costs of manufacturing the product
2.Increase sales through a change in the sales incentive structure or commissions (a variable cost)
3. Increase sales through increasing advertising (a fixed cost)

19. What-If Options Using CVP
When variable costs are reduced, contribution margin will increase.
Find less expensive supplier of raw material
Reduce the amount of labor used
Use lower-wage employees
What would be the consequences of each?

20. What-If Options Using CVP
Sales
Less: Variable Costs
Contribution Margin
Less: Fixed Costs
Net Income (Loss)
Total
$100,000
72,000
$28,000
35,000
$(7,000)
Option 1
$100,000
64,800
$35,200
35,000
$200

21. What-If Options Using CVP
Raise sales commissions on all sales above the present level by 10 percent. Sales will increase by $30,000 or 2,400 games. Additional sales commission will be $3,000.

22. What-If Options Using CVP
Impact of increasing Sales Incentives, Sales = $130,000
Sales
Less: Variable Costs
Contribution Margin
Less: Fixed Costs
Net Income (Loss)
Total
$100,000
72,000
$28,000
35,000
$(7,000)
Option 1
$130,000
96,600
$33,400
35,000
$(1,600)

23. What-If Options Using CVP
Option 2A
Increase net income by $5,400 by increasing the sales commission by 10 percent on all sales of more than $100,000.
The new variable costs = 72% of sales up to $100,000 and 82% on all sales over $100,000.

24. What-If Options Using CVP
Spending an additional $10,000 on advertising will increase sales by $40,000 or 3,200 games.

25. What-If Options Using CVP
Impact of increasing Sales Incentives, Sales = $140,000
Sales
Less: Variable Costs
Contribution Margin
Less: Fixed Costs
Net Income (Loss)
Total
$100,000
72,000
$28,000
35,000
$(7,000)
Option 3
$140,000
100,800
$39,200
45,000
$(5800)

26. What-If Options Using CVP
Step 4: Select the best option
Option 1, NI = $200
Option 2, NI = $(1,600)
Option 2a, NI = $200
Option 3, NI = $(5,800)
Assess risk inherent in each option
Assess sensitivity of a decision to changes in key assumptions

27. Changes in Price and Volume
If the manager changes the sales price resulting in a change in sales volume, what will be the impact on net income?
Raising the sales price may decrease sales volume but the impact on total sales revenue may be offset by the increase in sales price.
Decreasing the sales price may increase the sales volume without increasing total sales revenue.

28. Changes in Price and Volume
These business strategies decisions involve individuals in many areas of an organization, such as marketing, sales, production management, and even human resources personnel for hiring decisions. The implications of a bad decision in this area can affect the firm’s bottom line.

29. Changes in Cost, Price and Volume
Changes can be made to cost, price and volume at the same time.
Changes in one almost always impact one or both of the other variables.

30. Break-Even Analysis
Break-Even Point: the level of sales where contribution margin just covers fixed costs and consequently net income is equal to zero.

31. Break-Even Analysis Break-Even (units) Fixed Costs
Contribution Margin Per Unit =
Break-Even (Sales $)
Fixed Costs
Contribution Margin% =

32. Break-Even Graph $ Volume Revenue Break-Even Point Income Total Cost
Loss
Break-Even
Point
in $
Break-Even Point in Volume
Volume

33. Break-Even Calculations with Multiple Products
The calculation of “average” contribution margin is really a weighted average.
Fixed Costs
Weighted Average Contribution Margin Ratio
Break-Even Point =

34. Break-Even Calculations with Multiple Products
Pause and Reflect
Imagine how difficult it is for large retail stores such as Wal-Mart or JCPenney to compute a break-even point for the entire store or company.

35. Break-Even Calculations with Multiple Products
When using ABC, costs are classified as unit, batch, product, or facility level instead of variable or fixed.
Break-Even (units) =
Fixed Costs + Batch-level costs + Product-level costs
Contribution Margin Per Unit

36. Target Profit Analysis (Before and After Tax)
To determine the sales units required to achieve a Target Profit before taxes:
Sales (units) =
Fixed Costs + Target Profit (before taxes)
Contribution Margin Per Unit

37. Target Profit Analysis (Before and After Tax)
Multiple Product formula to reach a Target Profit:
Sales (units) =
Fixed Costs + Target Profit
Weighted Average Contribution Margin Per Unit

38. Target Profit Analysis (Before and After Tax)
ABC Formula to reach a Target Income:
Sales (units) =
Fixed Costs + Batch-level Costs + Product-level Costs + Target Profit
Contribution Margin Per Unit

39. The Impact of Taxes If
After-Tax Profit = Before-Tax Profit (1-tax rate)
then
Before-Tax Profit = After-Tax Profit / (1-tax rate)
Therefore, to determine after-tax Target Income
Fixed costs + After-Tax Profit / (1-tax rate)
Contribution Margin per unit
Sales in units =

40. The Impact of Taxes Key Concept
The payment of income tax is an important variable in target profit and other CVP decisions.

41. The Impact of Taxes Pause and reflect
What impact do income taxes have on the calculation of the break-even point?

42. Assumptions of CVP Analysis
Selling price is constant throughout the relevant range.
Costs are linear throughout the relevant range.
The sales mix used to calculate the weighted average contribution margin is constant.
The amount of inventory is constant.

43. Cost Structure and Operating Leverage
Operating Leverage: The measure of the proportion of fixed costs in a company’s cost structure. It is used as an indicator of how sensitive profit is to changes in sales volume.

44. Cost Structure and Operating Leverage
Contribution Margin
Net Income
Operating Leverage =
Multiply OL x % increase in Sales = % increase in Net Income

45. Cost Structure and Operating Leverage
Company A B C
Sales
Cont. Margin
Net Income
$100,000
$ 60,000
$ 20,000
$200,000
$120,000
$ 80,000
$400,000
$240,000
$200,000
Operating Leverage
60,000 20,000
120,000 80,000
240, ,000 =
10% Inc Sales 30% 15% 12%

46. Cost Structure and Operating Leverage
Pause and Reflect
Unlike measures of contribution margin, operating leverage changes as sales change.

47. Cost Structure and Operating Leverage
Key Concept
A company operating near the break-even point will have a high level of operating leverage and income will be very sensitive to changes in sales volume.

48. Variable Costing for Decision Making
The only difference between absorption and variable costing is the treatment of fixed overhead.
Absorption Costing: FO is treated as a product cost, and expensed when the product is sold.
Variable Costing: FO is treated as a period cost and expensed as incurred.

49. Variable Costing for Decision Making
Absorption Costing
Variable Costing
Sales
Less: Cost of Goods Sold
Variable Costs
Fixed Costs
Total Costs of Goods Sold
Gross Profit
Less: S&A Costs
Total S&A Costs
Net Income
$1,000
350
150
$ 500
$ 50
250
$ 300
$ 200
Sales
Less: Variable Costs
Manuf. Costs
S&A Costs
Total Variable Costs
Contribution Margin
Less: Fixed Costs
Total Fixed Costs
Net Income
$1,000
$350 50
$400
$600
$150
250
$200

50. Variable Costing for Decision Making
Absorption Costing
Variable Costing
Product Cost
Direct Material
Direct Labor
Variable Overhead
Fixed Overhead
Period Cost
Sell. & Adm.
Product Cost
Direct Material
Direct Labor
Variable Overhead
Fixed Overhead
Period Cost
Fixed OH
Sell. & Adm.

51. Variable Costing for Decision Making
Product Costs
Absorption Costing
Variable Costing
Direct Material
Direct Labor
Variable Overhead
Fixed Overhead
Total per unit
$.30
.35
.10
.30
$1.05
Direct Material
Direct Labor
Variable Overhead
Total per unit
$.30
.35
.10
$.75
.30

52. Differences Between Absorption and Variable Costing
When units sold equal units produced, net income is the same under both costing methods.
When units produced exceed units sold, absorption costing will report higher net income than variable costing.
When units sold exceeds units produced, variable costing will report higher net income than absorption costing.

53. Variable Costing for Decision Making
Key Concept
Variable costing is consistent with CVP’s focus on differentiating fixed from variable costs, and provides useful information for decision making that is often not apparent when using absorption costing.

54. Variable Costing for Decision Making
I’m ready! Bring on the costs!