1 Copyright © 2008 Cengage Learning South-Western. Heitger/Mowen/Hansen Cost-Volume-Profit Analysis: A Managerial Planning Tool Chapter Three Fundamental Cornerstones of Managerial Accounting

2 Cost-Volume-Profit Analysis A powerful tool for planning and decision making. It can be used to calculate: The number of units that must be sold to break-even The impact of a given reduction in fixed costs on the break- even point. The impact of an increase in price on profit.

3 Break-Even Point Total Revenue Or to put it another way: – Total Cost = Total Revenue Zero Profit Total Cost

4 Contribution Margin Sales - Variable Expense Contribution Margin = Contribution Margin is then used to cover Fixed Costs and Operating Income. Using Operating Income in Cost-Volume-Profit Analysis

5 Contribution Margin Income Statement Divides costs based on behavior Costs are divided into variable and fixed components Important subtotal is contribution margin ◦Sales revenue minus variable expenses

6 Contribution Margin Sales - Variable Expense Contribution Margin = Break-even point is when Operating Income is zero. Contribution Margin - Fixed Costs = Operating Income

7 Units to Be Sold to Achieve a Target Income Two ways: 1.Using Operating Income equation 2.Using the Basic Break-even equation Cornerstone 4-5 will walk us through these computations

8 Number of units to earn target income = Fixed Cost + Target Income $400 - $325 Price – Variable Cost per unit $45,000 + $37,500 = Units to Be Sold to Achieve a Target Income Number of units to earn target income = 1,100

9 Sales Revenue to Achieve a Target Income Sales dollars to earn target income = Fixed Cost + Target Income Contribution margin ratio $45,000 + $37,500 $440,000 Sales dollars to earn target income = =

10 Profit-Volume Graph Visually portrays the relationship between profits and units sold Operating Income is the dependent variable Units sold is the independent variable

11 Cost-Volume-Profit Graph Depicts the relationship among cost, volume, and profits To obtain the more detailed relationships, it is necessary to graph two separate lines: ◦Total revenue ◦Total cost The vertical axis is measured in dollars The horizontal axis is measured in units sold

12 Assumptions of Cost-Volume- Profit Analysis Revenue and cost functions are linear Price, total fixed costs, and unit variable costs can be identified and remain constant over relevant range All units produced are sold-there are no change in inventory levels Sales mix is constant Selling prices and costs are known with certainty

13 Linear Cost and Revenue Functions Cost-Volume-Profit assumes that cost and revenue functions are linear. In other words they are straight lines.

14 Production Equal to Sales Cost-Volume-Profit assumes that what is produced is actually sold Inventory levels do not change over the period CVP focuses on current costs by excluding inventory costs of previous periods

15 Constant Sales Mix Multiple product break-even analysis requires a constant sales mix. Relative combination of products being sold by a firm Sales mix is difficult to predict with certainty

16 Certainty of Prices and Costs In actuality, firms seldom know prices, variable costs, and fixed costs with certainty. There are formal ways of explicitly building uncertainty into the Cost-Volume-Profit model.

17 Multiple-Product Analysis Cost-Volume-Profit analysis becomes more complex with multiple products. We need to adapt the single-product formulas.

18 Direct Fixed Expenses Those fixed costs that can be traced to each segment and would be avoided if the segment did not exist.

19 Common Fixed Expenses The fixed costs that are not traceable to the segments and would remain even if one of the segments was eliminated.

20 Multiple-Product Analysis Key is to identify the expected sales mix. Sales mix is the relative combination of products being sold by a firm. Break-even point in units

21 Sales Mix Measured in units sold Reduced to the smallest possible whole numbers Required in order to determine break even point in units

22 Changes in any of the above will affect the sales mix. CVP Analysis: Risk and Uncertainty The break-even point can be affected by changes in: ◦Price ◦Unit contribution margin ◦Fixed cost

23 Risk and Uncertainty Effects on Managers Management must realize the uncertain nature of future prices, costs, and quantities. Managers move from consideration of a break-even point to what might be called a “break-even band”. Managers may engage in sensitivity or what-if analysis.

24 Margin of Safety The units sold or the revenue earned above the break-even volume. Can be viewed as a crude measure of risk. ◦When there is a downturn in sales, the risk of suffering losses will be less if the firm’s margin of safety is large than if the margin of safety is small.

25 Margin of Safety Margin of Safety in units = Sales in units Break-even units - Margin of Safety in units = 1, Margin of Safety in units = 400

26 Margin of Safety Margin of Safety in sales revenue = Sales Break-even sales - Margin of Safety in sales revenue = $400(1,000) - $400(600) Margin of Safety in sales revenue = $160,000

27 Operating Leverage The relative mix of fixed costs to variable costs in a company Higher proportions of fixed costs to the amount of variable costs create higher operating leverage The greater the degree of operating leverage, the larger the effect on operating income when sales change Degree of Operating Leverage Operating Income Contribution Margin =

28 The degree of operating leverage (DOL) can be measured for a given level of sales. Degree of operating leverage = Contribution Margin Operating Income Operating Leverage ($400 – $325)(1,000 units) $30,000 Degree of operating leverage = = 2.5

29 % change in operating leverage = DOL % change in sales Percentage Change in Operating Leverage 2.5 = = 50% x 20% x % change in operating leverage

30 Expected Operating Income $30,000 = (% change x Orig. operating income) + (0.50 x $30,000) Expected Operating Income = $45,000 Expected Operating Income = Original operating income +