2009 Foster Business School Cost Accounting L.DuCharme 1 Cost-Volume-Profit Analysis Chapter 3

2009 Foster Business School Cost Accounting L.DuCharme 2 Outline CVP assumptions & terminology BEP solution –Target operating income –Target net income Margin of Safety Operating Leverage CM vs. GM

2009 Foster Business School Cost Accounting L.DuCharme 3 Assumptions Four assumptions underlying cost-volume-profit (CVP) analysis are presented in the text. We will assume that they hold here.

2009 Foster Business School Cost Accounting L.DuCharme 4 Cost-Volume-Profit Terminology Operating income = Total revenues from operations – Cost of goods sold and operating costs (excluding income taxes) Net income = Operating income – Income taxes

2009 Foster Business School Cost Accounting L.DuCharme 5 (CVP) Analysis Example Assume that the Pants Shop can purchase pants for $32 from a local factory; other variable costs amount to $10 per unit. The local factory allows the Pants Shop to return all unsold pants and receive a full $32 refund per pair of pants within one year. The average selling price per pair of pants is $70 and total fixed costs amount to $84,000.

2009 Foster Business School Cost Accounting L.DuCharme 6 (CVP) Analysis Example How much revenue will the business receive if 2,500 units are sold? 2,500 × $70 = $175,000 How much variable costs will the business incur? 2,500 × $42 = $105,000 $175,000 – 105,000 – 84,000 = ($14,000)

2009 Foster Business School Cost Accounting L.DuCharme 7 (CVP) Analysis Example What is the contribution margin per unit? $70 – $42 = $28 contribution margin per unit What is the total contribution margin when 2,500 pairs of pants are sold? 2,500 × $28 = $70,000

2009 Foster Business School Cost Accounting L.DuCharme 8 (CVP) Analysis Example Contribution margin percentage (contribution margin ratio) is the contribution margin per unit divided by the selling price. What is the contribution margin percentage? $28 ÷ $70 = 40%

2009 Foster Business School Cost Accounting L.DuCharme 9 (CVP) Analysis Example If the business sells 3,000 pairs of pants, revenues will be $210,000 and contribution margin would equal 40% × $210,000 = $84,000.

2009 Foster Business School Cost Accounting L.DuCharme 10 BEPs Determine the breakeven point and output level needed to achieve a target operating income using: (1) the equation, (2) contribution margin, and (3) graph methods.

2009 Foster Business School Cost Accounting L.DuCharme 11 Breakeven Point Sales Variable expenses Fixed expenses – = Total revenues = Total costs Rev – VC – FC = 0

2009 Foster Business School Cost Accounting L.DuCharme 12 Abbreviations SP = Selling price VCU = Variable cost per unit CMU = Contribution margin per unit CM% = Contribution margin percentage FC = Fixed costs

2009 Foster Business School Cost Accounting L.DuCharme 13 Abbreviations Q = Quantity of output units sold (and manufactured) OI = Operating income TOI = Target operating income TNI = Target net income (after tax)

2009 Foster Business School Cost Accounting L.DuCharme 14 Equation Method $70Q – $42Q – $84,000 = 0 $28Q = $84,000 Q = $84,000 ÷ $28 = 3,000 units Let Q = number of units to be sold to break even (Selling price × Quantity sold) – (Variable unit cost × Quantity sold) – Fixed costs = Operating income

2009 Foster Business School Cost Accounting L.DuCharme 15 Contribution Margin Method $84,000 ÷ $28 = 3,000 units $84,000 ÷ 40% = $210,000

2009 Foster Business School Cost Accounting L.DuCharme 16 Graph Method Revenue Total costs Breakeven Fixed costs

2009 Foster Business School Cost Accounting L.DuCharme 17 Target Operating Income (Fixed costs + Target operating income) divided either by Contribution Margin percentage or Contribution Margin per unit

2009 Foster Business School Cost Accounting L.DuCharme 18 Target Operating Income Assume that management wants to have an operating income of $14,000. How many pairs of pants must be sold? ($84,000 + $14,000) ÷ $28 = 3,500 What dollar sales are needed to achieve this income? ($84,000 + $14,000) ÷ 40% = $245,000

2009 Foster Business School Cost Accounting L.DuCharme 19 Income Taxes Understand how income taxes affect CVP analysis.

2009 Foster Business School Cost Accounting L.DuCharme 20 Target Net Income and Income Taxes Example Management would like to earn an after tax income of $35,711. The tax rate is 30%. What is the target operating income? Target operating income = Target net income ÷ (1 – tax rate) TOI = $35,711 ÷ (1 – 0.30) = $51,016

2009 Foster Business School Cost Accounting L.DuCharme 21 Target Net Income and Income Taxes Example How many units must be sold? Revenues – Variable costs – Fixed costs = Target net income ÷ (1 – tax rate) $70Q – $42Q – $84,000 = $35,711 ÷ 0.70 $28Q = $51,016 + $84,000 Q = $135,016 ÷ $28 = 4,822 pairs of pants

2009 Foster Business School Cost Accounting L.DuCharme 22 Target Net Income and Income Taxes Example Proof: Revenues: 4,822 × $70$337,540 Variable costs: 4,822 × $42 202,524 Contribution margin$135,016 Fixed costs 84,000 Operating income 51,016 Income taxes: $51,016 × 30% 15,305 Net income$ 35,711

2009 Foster Business School Cost Accounting L.DuCharme 23 Margin of Safety (MoS) Margin of Safety = Revenues* – BEP (*Revenues are either budgeted or actual.) MoS can either be expressed in # of units or $.

2009 Foster Business School Cost Accounting L.DuCharme 24 MoS--question Brie Soda has sales of $200,000; a CM of 20%; and a margin of safety of $80,000. What is Brie’s fixed cost? A.$16,000 B.$24,000 C.$80,000 D.$96,000 E.None of the above

2009 Foster Business School Cost Accounting L.DuCharme 25 Operating Leverage Operating leverage describes the effects that fixed costs have on changes in operating income as changes occur in units sold. Organizations with a high proportion of fixed costs have high operating leverage.

2009 Foster Business School Cost Accounting L.DuCharme 26 Operating Leverage Example Degree of operating leverage = Contribution margin ÷ Operating income What is the degree of operating leverage of the Pants Shop at the 3,500 sales level under two different arrangements? Existing arrangement: 3,500 × $28 = $98,000 contribution margin

2009 Foster Business School Cost Accounting L.DuCharme 27 Operating Leverage Example $98,000 contribution margin – $84,000 fixed costs = $14,000 operating income $98,000 ÷ $14,000 = 7.0 New arrangement: Assume Unit Variable Costs = $35 and Fixed Cost = $114,000 3,500 × $35 = $122,500 contribution margin

2009 Foster Business School Cost Accounting L.DuCharme 28 Operating Leverage Example $122,500 contribution margin – $114,000 fixed costs = $8,500 $122,500 ÷ $8,500 = 14.4 The degree of operating leverage at a given level of sales helps managers calculate the effect of fluctuations in sales on operating income. E.g., above: a 10% increase in sales will yield a 144% increase in op. income! What is operating leverage if fixed costs = 0? As sales increase, what happens to op. leverage?

2009 Foster Business School Cost Accounting L.DuCharme 29 Contribution Margin versus Gross Margin Contribution income statement emphasizes contribution margin. Financial accounting income statement emphasizes gross margin.

2009 Foster Business School Cost Accounting L.DuCharme 30 GM versus CM The difference between GM and CM all is in how you account for: –Fixed mfg. costs (in CoGS, NOT in VC) –Variable non-mfg. costs (in VC, NOT in CoGS) GM = Rev. – CoGS CM = Rev. – VC “Margins” are usually referred to in finance. What margins are they usually referring to?

2009 Foster Business School Cost Accounting L.DuCharme 31 End of Chapter 3