Cost-Volume-Profit Analysis CHAPTER 3 Cost-Volume-Profit Analysis Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Chapter 3 learning objectives Explain the features of cost-volume-profit (CVP) analysis Determine the breakeven point and output level needed to achieve a target operating income Understand how income taxes affect CVP analysis Explain how managers use CVP analysis to make decisions Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Chapter 3 learning objectives, cont’d Explain how sensitivity analysis helps managers cope with uncertainty Use CVP analysis to plan variable and fixed costs Apply CVP analysis to a company producing multiple products Apply CVP analysis in service and not-for- profit organizations Distinguish contribution margin from gross margin Copyright © 2015 Pearson Education, Inc. All Rights Reserved

What is CVP? How is it used? Managers want to know how profits will change as the units sold of a product or service changes. Managers like to use “what-if” analysis to examine the possible outcomes of different decisions so they can make the best one. In Chapter 2, we discussed total revenues, total costs and income. In this chapter, we take a closer look at the relationship among the elements (selling price, variable costs, fixed costs). CVP is an abbreviation for Cost Volume Profit. This is an analysis tool that managers use to understand how profits will change as units sold, variable costs, fixed costs or selling price change. CVP is about the relationship among these elements. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

A Five-Step Decision-Making Process in Planning and Control - Revisited Identify the problem and uncertainties. Obtain information. Make predictions about the future. Make decisions by choosing between alternatives, using cost-volume-profit (CVP) analysis. Implement the decision, evaluate performance, and learn. In chapter 1, we illustrated the five-step decision-making process we see here. Identify the problem and uncertainties Obtain information Make predictions about the future Make decisions by choosing between alternatives, using cost-volume-profit (CVP) analysis Implement the decision, evaluate performance, and learn Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Foundational Assumptions USED in CVP ANALYSIS Changes in production/sales volume are the sole cause for cost and revenue changes. Total costs consist of fixed costs and variable costs. Revenue and costs behave and can be graphed as a linear function (a straight line). Selling price, variable cost per unit, and fixed costs are all known and constant. In many cases only a single product will be analyzed. If multiple products are studied, their relative sales proportions are known and constant. The time value of money (interest) is ignored. To conduct a CVP analysis, we need to correctly distinguish fixed from variable costs, recognizing that whether a cost is variable or fixed depends on the time period within which a decision will be made. Additional assumptions followed in a CVP analysis are: Changes in production/sales volume are the sole cause for cost and revenue changes. Total costs consist of fixed costs and variable costs. Revenue and costs behave and can be graphed as a linear function (a straight line). Selling price, variable cost per unit, and fixed costs are all known and constant. In many cases only a single product will be analyzed. If multiple products are studied, their relative sales proportions are known and constant. The time value of money (interest) is ignored. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

CVP: Contribution Margin Manipulation of the basic equations yields an extremely important and powerful tool extensively used in cost accounting: contribution margin (CM). Contribution margin equals revenue less variable costs. Contribution margin per unit equals unit selling price less unit variable costs or can be obtained by taking contribution margin divided by number of units sold. Taking a portion of the basic formula, which you’ll recall from the prior slide is revenue LESS variable costs LESS fixed costs EQUAL operating income, we can subtract variable costs from revenue to obtain contribution margin. Going a step further, contribution margin divided by number of units sold equals contribution margin per unit. You can also obtain contribution margin per unit by subtracting variable cost per unit from selling price. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

CVP: Contribution Margin Additional calculations You can also calculate: Contribution margin which is equal to the contribution margin per unit multiplied by the number of units sold. Contribution margin percentage which is the contribution margin per unit divided by unit selling price or Contribution margin divided by revenue. Contribution margin which we previously calculated by subtracting variable costs from revenues can also be obtained by multiplying contribution margin per unit by the number of units sold. Contribution margin percentage provides information about the relationship between selling price and variable costs. It can be calculated by contribution margin divided by revenue or contribution margin per unit by selling price. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Cost–Volume–Profit Equation REVENUE – VARIABLE - FIXED = OPERATING COSTS COSTS INCOME ( Selling Price * Quantity of Units Sold ) - Unit Variable Costs Fixed Costs = Operating Income Keep in mind the following: Selling Price * Quantity of Units Sold = Revenue Unit Variable Costs * Quantity of Units Sold = Variable Costs Revenue – Variable Costs = Contribution Margin Contribution Margin – Fixed Costs = Operating Income Let’s look at the basic equation a little differently. Remember the original equation: Revenue less variable costs less fixed costs = operating income Now we’ll remember that revenue = selling price x sales quantity and variable costs = unit variable costs x sales quantity. Dissecting our basic equation in this manner helps to emphasize the relationships between these cost elements which will, in turn, provide a greater understanding of the concepts that follow such as breakeven. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Breakeven Point Calculation of breakeven number of units At the breakeven point, a firm has no profit or loss at the given sales level. Breakeven is where: Sales – Variable Costs – Fixed Costs = 0 Calculation of breakeven number of units Breakeven Units = Fixed Costs _ Calculation of breakeven revenues Breakeven Revenue = Fixed Costs _ Contribution Margin per Unit Breakeven is the point at which a firm has no profit or loss. It can be calculated in terms of unit sales or dollars (revenue). In both cases, the numerator will be fixed costs. To calculate breakeven in units, divide fixed costs by contribution margin PER UNIT. To calculate breakeven in sales dollars, divide fixed costs by contribution margin percentage. Contribution Margin Percentage Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Breakeven Point, extended: Profit Planning The breakeven point formula can be modified to become a profit planning tool by adding Target Operating Income to fixed costs in the numerator. Quantity of Units = (Fixed Costs+Target Operating Income) Required to Be Sold Contribution Margin per Unit Sometimes it is useful to know how many sales of a product are required to have all costs returned. Other times, we want to use the basic breakeven formula as a profit planning tool. To modify the formula in this manner, simply add target operating income to fixed costs in the numerator and divide by contribution margin per unit for the number of units required to be sold to earn the target operating income. Divide Fixed Costs by contribution margin percentage to obtain the sales revenue required to be sold to earn the target operating income. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Let’s review: emma Emma has fixed costs of $2,000 and a contribution margin percentage of 40%. If Emma wants to make a profit of $2,000, what must revenue equal? What if Emma wants to make a profit of $3,000, what must revenue equal? Remember the formula: (Fixed Cost+ Target Operating Income) / Contribution Margin % Let’s look at the details: In the example from the textbook, we’ve been reviewing Emma’s fledgling business selling a test-prep book and software package. Her fixed costs are $2,000 and she has a contribution margin percentage of 40%. If Emma wants to earn a profit of $2,000, her revenue would have to be $10,000. This is calculated by using our formula: (Fixed Cost + Target Operating Income) / Contribution Margin % (2000+2000)/.40 = 10,000 If Emma wants to earn a profit of $3,000, revenue would have to be $12,500. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

EMMA’s ANALYSIS FOR TARGET OPERATING INCOME For OPERATING INCOME of $2,000 Revenue=(FC+TOI)/CM% Revenue = (2,000+2,000)/.40 = For OPERATING INCOME of $3,000 Revenue=(FC+TOI)/CM% Revenue = (2,000+3,000)/.40 = Revenue = $10,000 Revenue = $12,500 On this slide, you’ll see the details of our calculations to determine Emma’s required revenue to achieve her operating income goals. If Emma wants to earn a profit of $2,000, her revenue would have to be $10,000. This is calculated by using our formula: (Fixed Cost + Target Operating Income) / Contribution Margin % (2000+2000)/.40 = 10,000 If Emma wants to earn a profit of $3,000, revenue would have to be $12,500.

CVP: Graphically The graph depicted here is a pictorial representation of the relationships of CVP. At the intersection of total costs and total revenue is the breakeven point. Below the breakeven point, the area between the two lines represents the operating loss and above the breakeven point, the area between the two lines represents the operating income. Exhibit 3-2 page 72. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

CVP and Income Taxes After-tax profit (Net Income) can be calculated by: Net Income = Operating Income * (1-Tax Rate) Net income can be converted to operating income for use in CVP equation Operating Income = I I Net Income I (1-Tax Rate) In our chapter so far, we’ve been assuming that nonoperating revenues and nonoperating expenses are zero. For purposes of this income tax illustration, we will continue that assumption. We’ve been ignoring the effect of income taxes thus far but must now recognize that in many companies, managers’ income targets are expressed in terms of net income rather than operating income. The key is to convert target net income into the corresponding target operating income which is what we use in our CVP formulae. The conversion formula, also shown on this slide, is net income divided by (1 – tax rate) = operating income. Note: The CVP equation will continue to use operating income. We’ll use this conversion formula to obtain the operating income value when provided with Net Income. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Profit Planning, Illustrated This chart presents a table view of the number of units required to be sold at 3 different levels of operating income, with three different levels of fixed costs and at three different variable costs per unit. On one page, we can easily view the answers to several “what-if” questions. For example, what if our fixed costs were $2,000, variable costs were $150/unit and we had a target operating income of $2,000. Looking at cell F7, we learn that Emma would need to sell 80 units. Exhibit 3-4 page 79. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Sensitivity Analysis CVP provides structure to answer a variety of “what-if” scenarios. “What” happens to profit “if”: Selling price changes. Volume changes. Cost structure changes. Variable cost per unit changes. Fixed costs change. CVP analysis is used in many decisions. It is used to decide whether or not to advertise, whether or not to increase or decrease prices. Sensitivity analysis is a what-if technique we use to examine how an outcome will change if the original predicted data are not achieved or if an underlying assumption changes. This type of analysis can answer, for an example, the question: What will operating income be if the quantity of units sold decreases by 5% from the original prediction? As an example, if a company determines that an ad campaign costing $15,000 is expected to increase sales 25%, should they proceed? That question cannot be properly answered without doing this type of analysis. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Margin of Safety-Defined The margin of safety calculation answers a very important question: If budgeted revenues are above the breakeven point, how far can they fall before the breakeven point is reached. In other words, how far can they fall before the company will begin to lose money. The margin of safety is an aspect of sensitivity analysis that answers the specific question: if budgeted revenues are currently above breakeven, how far can they fall before the breakeven point is reached. The answer to this question gives managers information they can use to take action and potentially prevent a fall in revenues below breakeven. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Margin of Safety An indicator of risk, the margin of safety (MOS), measures the distance between budgeted sales and breakeven sales: MOS = Budgeted Sales – BE Sales The MOS ratio removes the firm’s size from the output, and expresses itself in the form of a percentage: MOS Ratio = MOS ÷ Budgeted Sales Looking at the MOS as a ratio removes the size of the firm from the output. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

COST STRUCTURE Managers make strategic decisions that affect the cost structure of the company. The cost structure is simply the relationship of fixed costs and variable costs to total costs. We can use CVP-based sensitivity analysis to highlight the risks and returns as fixed costs are substituted for variable costs in a company’s cost structure. The risk-return trade-off across alternative cost structures can be measured as operating leverage. Cost structure is simply the relationship of fixed costs and variable costs relative to total costs. Managers make strategic decisions that affect the structure and that information is, of course, used in the CVP analysis we’ve been learning about. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Operating Leverage Operating leverage (OL) describes the effect that fixed costs have on changes in operating income as changes occur in units sold and contribution margin. OL = Contribution Margin Operating Income Notice that the difference between the numerator and the denominator in our formula = our fixed costs. The formula to calculate operating leverage, seen here on the slide, is Contribution Margin divided by Operating Income. Organizations with a high proportion of fixed costs in their cost structure are said to have high operating leverage. In this type of structure, small decreases in sales result in large decreases in operating income. Remember what fixed costs are. They are costs that do not change, in the short run, with the level of sales. These costs will exist whether sales are higher or lower, within that relevant range. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

USING OPERATING LEVERAGE TO ESTIMATE CHANGES IN OPERATING INCOME The formula to estimate the change in operating income that will result from a percentage change in sales is: Operating Leverage X % Change in Sales If sales increase 50% and operating leverage is 1.67, you should expect operating income to increase 83.5%. Operating leverage is more than just an indication of the cost structure. It can also be used to estimate the change in operating income that will result from a change in sales. To do so, take the operating leverage times the percentage change in sales. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Effects of Sales Mix on CVP The formulae presented to this point have assumed a single product is produced and sold. A more realistic scenario involves multiple products sold, in different volumes, with different costs and different margins. In this case, we use the same formulae, but use average contribution margins for the multiple products. This technique assumes a constant mix at different levels of total unit sales. Let’s turn now to the topic of sales mix. So far, we’ve been contemplating a business with one product and, therefore, one contribution margin. More usually, a company has multiple products with varying contribution margins. We can still use the tools of CVP analysis but instead of using the contribution margin for the one product, we will use an average contribution margin. The average CM is calculated based on a defined product mix. In other words, the CM is determined based on a specific relationship of sales of product 1 to total sales and sales of product 2 to total sales. If that relationship of sales changes, so will our average CM. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

CVP for SERVICE and Not-For-Profit organizations CVP isn’t just for merchandising and manufacturing companies. Service and Not-for-Profit businesses need to focus on measuring their output which is different from the units sold that we’ve been dealing with. For example, a service agency might measure how many persons they assist or an airline might measure how many passenger miles they fly. CVP, though more prevalent for manufacturing and merchandising companies, is certainly useful for service and not-for-profits as well. The challenge here is to focus on a measure of output which is generally going to be different from the measure of “units sold” that we’ve been dealing with so far. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Alternative Income Statement Formats-especially significant in THE manufacturing sector In our last slide, we contemplate the differences between a Contribution Income Statement and a Financial Accounting Income Statement. The former emphasizes contribution margin and the latter emphasizes gross margin. You may recall from earlier chapters that gross margin is obtained by subtracting all manufacturing costs from revenues. Those manufacturing costs will include fixed and variable components. On the contrary, as we’ve seen, contribution margin is obtained by subtracting all variable costs, both manufacturing and nonmanufacturing, from revenues. In a period where there is no change in inventory value, the operating income will not change between the two formats of income statement however the presentation is different. Both formats are important for their particular purposes and one shouldn’t be dismissed in favor of the other but each should be used for the particular purpose. Copyright © 2015 Pearson Education, Inc. All Rights Reserved

TERMs to learn Page Number Reference Breakeven point (BEP) Page 73 Choice criterion Page 90 Contribution income statement Page 69 Contribution margin Page 68 Contribution margin per unit Contribution margin percentage Contribution margin ratio Cost–volume–profit (CVP) analysis Page 67 Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Terms to learn, cont’d Page Number Reference Decision table Page 91 Degree of operating leverage Page 82 Event Page 90 Expected monetary value Expected value Gross margin percentage Page 88 Margin of safety Page 79 Net income Page 76 Operating leverage Copyright © 2015 Pearson Education, Inc. All Rights Reserved

TERMS to learn, concluded Page Number Reference Outcomes Page 91 Probability Page 90 Probability distribution PV graph Page 75 Revenue driver Page 72 Sales mix Page 84 Sensitivity analysis Page 79 Uncertainty Page 80 Copyright © 2015 Pearson Education, Inc. All Rights Reserved

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