1. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 15: Cost-Volume-Profit Analysis: A Managerial Planning Tool Cornerstones of Financial and Managerial Accounting, 2e

2. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Break-Even Point in Units and in Sales Dollars (continued) ►C►Companies use CVP analysis to help them reach important benchmarks, like breakeven point. ►T►The break-even point is the point where total revenue equals total cost (i.e., the point of zero profit). ►P►Put another way, the break-even point is the level of sales at which contribution margin just covers fixed costs and consequently operating income is equal to zero. ►S►Since new companies typically experience losses (negative operating income) initially, they view their first break-even period as a significant milestone. $$$$$$$$ 1

3. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Using Operating Income in Cost-Volume-Profit Analysis Direct materials Direct labor Variable overhead Variable selling and administrative costs Fixed selling and administrative costs Fixed overhead 1

4. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Using Operating Income in Cost-Volume-Profit Analysis (continued) 1

5. Break-Even Point in Units If the contribution margin income statement is recast as an equation, it becomes more useful for solving CVP problems. Basic CVP Equation © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1

6. Break-Even Point in Units To recap, the break-even units are equal to the fixed cost divided by the contribution margin per unit. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1

7. Break-Even Point in Sales Dollars Sometimes, managers using CVP analysis may prefer to use sales revenue as the measure of sales activity instead of units sold. A units sold measure can be converted to a sales revenue measure by multiplying the unit selling price by the units sold: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. For example, the break-even point for Whittier is 600 mowers; the selling cost is $400 per mower. So, Breakeven in Sales $’s = 600 x $400 = $240,000 1

8. Variable Cost Ratio and Contribution Margin Ratio Any answer expressed in units sold can be easily converted to one expressed in sales revenues. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Alternatively: 1

9. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Fixed Cost’s Relationship with the Variable Cost Ratio and the Contribution Margin Ratio ► Since the total contribution margin is the revenue remaining after total variable costs are covered, it must be the revenue available to cover fixed costs and contribute to profit. How does the relationship of fixed cost to contribution margin affect operating income? ► There are three possibilities: ► Fixed cost equals contribution margin; operating income is zero; the company breaks even. ► Fixed cost is less than contribution margin; operating income is greater than zero; the company makes a profit. ► Fixed cost is greater than contribution margin; operating income is less than zero; the company makes a loss. 1

10. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Units to Be Sold to Achieve a Target Income ► While the break-even point is useful information and an important benchmark for relatively young companies, most companies would like to earn operating income greater than $0. ► CVP allows us to do this by adding the target income amount to the fixed cost. ► First, let’s look in terms of the units that must be sold to earn a desired income. 2

11. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sales Revenue to Achieve a Target Income ► How much sales revenue must Whittier generate to earn an operating income of $37,500? This question is similar to the one we asked earlier in terms of units but phrases the question directly in terms of sales revenue. ► To answer the question, add the targeted operating income of $37,500 to the $45,000 of fixed cost and divide by the contribution margin ratio. This equation is: 2

12. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Impact of Change in Revenue on Change in Profit ► Assuming that fixed costs remain unchanged, the contribution margin ratio can be used to find the profit impact of a change in sales revenue. ► To obtain the total change in profits from a change in revenues, multiply the contribution margin ratio times the change in sales: Change in Profits Contribution Margin Ratio Change in Sales = x 2

13. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A profit-volume graph visually portrays the relationship between profits (operating income) and units sold. 3 ► The profit-volume graph is the graph of the operating income equation: Operating income = (Price x Units) - (Unit variable cost x Units) - Total fixed cost ► In this graph, operating income is the dependent variable, and units is the independent variable. Graphs of Cost-Volume-Profit Relationships: The Profit-Volume Graph

14. Graphs of Cost-Volume-Profit Relationships: The Cost-Volume-Profit Graph © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The cost-volume-profit graph depicts the relationships among cost, volume, and profits (operating income). 3

15. CVP Analysis Assumptions Major assumptions of CVP analysis include: Linear revenue and cost functions remain constant over the relevant range. Sales mix is known with certainty for multiple- product break-even settings. Selling prices and costs are known with certainty. All units produced are sold; no finished goods inventories remain. 12 34 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3

16. Multiple-Product Analysis ► Cost-volume-profit analysis is fairly simple in the single- product setting. However, most firms produce and sell a number of products or services. ► How do we adapt the formulas used in a single-product setting to a multiple-product setting? ► One important distinction is to separate direct fixed expenses from common fixed expenses. ► Direct fixed expenses are those fixed costs that can be traced to each segment and would be avoided if the segment did not exist. ► Common fixed expenses are the fixed costs that are not traceable to the segments and would remain even if one of the segments was eliminated. 4

17. Break-Even Calculations for Multiple Products © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4

18. Cost-Volume-Profit Analysis and Risk and Uncertainty Managers must be aware of so many factors in our dynamic world. CVP analysis is a tool that managers use to handle risk and uncertainty. Variable costs?? Fixed costs?? Changes in prices?? Risks?? Uncertainty?? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5

19. Methods to Deal with Uncertainty and Risk 1 2 3 Managers should use sensitivity or “what-if” analyses. Management must realize the uncertain nature of future prices, costs, and quantities. Management must assume a breakeven “band” rather than a breakeven point. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5

20. Margin of Safety © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 ► The margin of safety is the units sold or the revenue earned above the break-even volume. ► For example, if the break-even volume for a company is 200 units and the company is currently selling 500 units, the margin of safety in units is: Sales - Break- even units = 500 – 200 = 300 units ► If the break-even volume for a company is $200,000 and the current revenues are $500,000, the margin of safety in sales revenue is: Revenue - Break-even volume = $500,000 – 200,000 = $300,000 ► The margin of safety as a percentage of total sales dollars can then be expressed as: Margin of safety ÷ Revenues = $300,000 ÷ $500,000 = 60%

21. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ► Operating leverage is use of fixed costs to extract higher percentage changes in profits as sales activity changes. ► Operating leverage is 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. 5 Operating Leverage

22. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ► The degree of operating leverage (DOL) can be measured for a given level of sales by taking the ratio of contribution margin to operating income or: Contribution margin ÷ Operating income 5 Operating Leverage (continued)

23. Summary of Operating Leverage OperatingLeverage HIGHLOW % profit increase with sales increase LargeSmall % loss increase with sales decrease LargeSmall © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5

24. Sensitivity Analysis 5