Cost volume profit analysis Chapter 17 Cost volume profit analysis

Cost volume profit (CVP) analysis A technique used to determine the effects of changes in an organisation’s sales volume on its costs, revenue and profit Can be used in profit-seeking and not-for profit organisations Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith The break-even point The volume of sales where the total revenues and expenses are equal, and the operation breaks even Can be calculated for an entire organisation or individual projects or activities Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Formulas Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Terminology Contribution margin (or variable costing) statement A reporting format where costs are reported by cost behaviour and a contribution margin is calculated Total contribution margin The difference between the sales revenue and the variable costs The amount available to cover fixed costs and then contribute to profits continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Terminology Unit contribution margin The difference between the sales price per unit and variable cost per unit Contribution margin ratio The unit contribution margin divided by the unit sales price The proportion of each sales dollar available to cover fixed costs and earn a profit continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Terminology Contribution margin percentage The unit contribution margin ratio multiplied by 100 The percentage of each sales dollar available to cover fixed costs and earn a profit Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Cost volume profit (CVP) graph Shows how costs, revenue and profits change as sales volume changes Five steps Draw the fixed expense line Draw the total expense line Draw the total revenue line Break-even point—where the total revenue and total expense lines intersect Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Profit volume (PV) graph Shows the total amount of profit or loss at different sales volumes The graph intercept the vertical axis at the amount equal to the fixed costs The break-even point is the point at which the line crosses the horizontal axis Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Target net profit A desired profit level determined by management Can be used within the break-even formula Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

CVP analysis and management decision making Common applications include Safety margin Changes in fixed expenses Changes in the unit contribution margin Multiple changes in key variables Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith 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 Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Changes in fixed expenses When estimates of fixed costs are revised, the break-even point will change 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/production volume More than one break-even point Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Changes in the unit contribution margin Change in unit variable expenses Changes the unit contribution margin A new break-even point An increase in unit variable expenses will increase the break-even point continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Changes in the unit contribution margin Change in sales price Changes the unit contribution margin A new break-even point An increase in unit price will lower the break-even point Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Multiple changes in key variables May involve Increasing unit prices Undertaking an advertising campaign Hiring a new storage facility An incremental approach Focuses on the difference in the total contribution margin, fixed expenses and profits under the two alternatives Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

CVP analysis with multiple products Sales mix The relative proportions of each type of product sold by the organisation Weighted average unit contribution margin The average of the products’ unit contribution margins, weighted by the sales mix Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Including income taxes Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Assumptions underlying CVP analysis The behaviour of total revenue is linear The behaviour of total costs is linear over a relevant range Costs can be categorised as fixed, variable or semivariable Labour productivity, production technology and market conditions do not change There are no capacity changes during the period under consideration continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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 Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

CVP analysis and long-term decisions CVP analysis is usually regarded a short-term or tactical decision tool Classification of costs as variable or fixed is usually based on cost behaviour over the short-term The financial impact of long-term decisions best analysed using capital budgeting techniques Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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, or stand-alone projects For larger firms, CVP analysis can be valuable as a decision tool for the planning stages of new projects and ventures Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

An activity-based approach to CVP analysis ABC categorises activities as facility, product, batch or unit costs Facility, product and batch activities are non-volume activity costs Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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 Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Sensitivity analysis and CVP analysis An approach which examines how an outcome may change due to variations in the predicted data or underlying assumptions Can be run using spreadsheet software, such as Excel continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Sensitivity analysis and CVP analysis Goal seeking approaches Allows the analyst to specify the outcome, so that software can specify the necessary inputs What-if analysis The analyst specifies changes in assumptions to examine the effect of these changes on the output Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith