Cost-Volume-Profit Analysis CHAPTER 7 Cost-Volume-Profit Analysis © 2009 Cengage Learning

Introduction Cost-volume-profit (CVP) analysis focuses on the following factors: The prices of products or services The volume of products or services produced and sold The per-unit variable costs The total fixed costs The mix of products or services produced

The Contribution Margin Income Statement The contribution margin income statement is structured by behavior rather than by function. Sales - All Variable Costs = Contribution Margin Contribution Margin - All Fixed Costs = Net Income

Income Statements TRADITIONAL CONTRIBUTION MARGIN Sales Less: Cost of Goods Sold: Variable Costs Fixed Costs Total Cost of Goods Sold Gross Profit Less: S, G, & A Costs: Total S, G, & A Costs Net Income $1,000 350 150 $ 500 $ 50 250 $ 300 $ 200 Sales Less: Variable Costs: Manuf. Costs S, G, & A Costs Total Variable Costs Contribution Margin Less: Fixed Costs: Total Fixed Costs Net Income $1,000 $350 50 $400 $600 $150 250 $200

The Contribution Margin Income Statement Key Concept The contribution margin income statement is structured to emphasize cost behavior as opposed to cost function.

Contribution Margin Per Unit Sales (100,000 units) Less: Variable Costs Contribution Margin Less: Fixed Costs Net Income Total $200,000 80,000 $120,000 40,000 $80,000 Per Unit $2.00 .80 $1.20

Contribution Margin Per Unit What if Cheri’s Chips sold one more unit? Total $200,002.00 80,000.80 $120,001.20 40,000.00 $80,001.20 Per Unit $2.00 .80 $1.20 Sales (100,001 units) Less: Variable Costs Contribution Margin Less: Fixed Costs Net Income

Contribution Margin Per Unit Key Concept For every unit change in sales, contribution margin will increase or decrease by the contribution margin per unit multiplied by the increase or decrease in sales volume.

Contribution Margin Ratio Is equal to Contribution Margin (in $) Sales (in $)

Contribution Margin Ratio Sales (100,000 units) Less: Variable Costs Contribution Margin Less: Fixed Costs Net Income Total $200,000 80,000 $120,000 40,000 $80,000 Percent 100% 40 60% $120,000 $200,000

Contribution Margin Ratio Key Concept The contribution margin per unit and the contribution margin ratio will remain constant as long as sales vary in direct proportion with volume.

Contribution Margin Ratio Key Concept For every dollar change in sales, contribution margin will increase or decrease by the contribution margin ratio multiplied by the increase or decrease in sales dollars.

The Contribution Margin and Its Uses What would happen if sales increase? Use the CM to determine the increase in net income. Then consider options to increase sales. Lower sales price? Increase incentives for sales staff? Improve quality of product? Increase advertising budget?

Option 1: Reduce variable costs. Decisions Using CVP Option 1: Reduce variable costs. When variable costs are reduced, contribution margin will increase. Options? Find less expensive supplier of raw material Reduce the amount of labor used Use lower-wage employees What would be the consequences of each?

Decisions Using CVP Lower Variable Costs by $7,200 Sales Less: Variable Costs Contribution Margin Less: Fixed Costs Net Income (Loss) Current $200,000 80,000 $120,000 40,000 $80,000 Option 1 $200,000 72,800 $127,200 40,000 $87,200

Decisions Using CVP Option 2: Change incentive structure Raise sales commissions on all sales above the present level by 10 percent. Sales will increase by $30,000 or 15,000 bags. Additional sales commission will be $3,000.

Impact of increasing Sales Incentives, Sales = $230,000 Decisions Using CVP Impact of increasing Sales Incentives, Sales = $230,000 Sales Less: Variable Costs Contribution Margin Less: Fixed Costs Net Income (Loss) Total $200,000 80,000 $120,000 40,000 $80,000 Option 2 $230,000 95,000 $135,000 40,000 $95,000 Variable Costs: 230,000*.40% + $3,000

Decisions Using CVP Option 3: Increase Advertising Spending an additional $10,000 on advertising will increase sales by $40,000 or 20,000 bags.

Decisions Using CVP Impact of increasing advertising: Sales = $140,000 Current $200,000 80,000 $ 120,000 40,000 $ 80,000 Option 3 $240,000 96,000 $ 144,000 50,000 $ 94,000 Sales Less: Variable Costs Contribution Margin Less: Fixed Costs Net Income (Loss)

Changes in Price and Volume If the manager changes the sales price resulting in a change in sales volume, what will be the impact on net income? Raising the sales price may decrease sales volume but the impact on total sales revenue may be offset by the increase in sales price. Decreasing the sales price may increase the sales volume without increasing total sales revenue.

Changes in Price and Volume These business decisions involve individuals in many areas of an organization, such as marketing, sales, production management, and even human resources personnel for hiring decisions. The implications of a bad decision in this area can affect the firm’s bottom line.

Changes in Cost, Price, and Volume Changes can be made to cost, price, and volume at the same time. Changes in one variable almost always impact one or both of the other variables.

Break-Even Analysis Break-Even Point: The level of sales where contribution margin just covers fixed costs and consequently net income is equal to zero.

Contribution Margin Per Unit Contribution Margin Ratio Break-Even Analysis Break-Even (units) Fixed Costs Contribution Margin Per Unit = Break-Even (Sales $) Fixed Costs Contribution Margin Ratio =

Break-Even Graph $ Volume Revenue Break-Even Point Profit Area Total Cost Break-Even Point in $ Break-Even Point in Volume Volume Loss Area

Break-Even Calculations with Multiple Products The calculation of “average” contribution margin is really a weighted average. Fixed Costs Weighted Average Contribution Margin Per Unit Break-Even (Units) =

Break-Even Calculations Using Activity-Based Costing When using activity-based-costing, costs are classified as unit, batch, product, or facility level instead of variable or fixed. Break-Even (units) = Fixed Costs + Batch-Level Costs + Product-Level Costs Contribution Margin Per Unit

Target Profit Analysis (Before and After Tax) To determine the sales units required to achieve a target profit before taxes: Sales Volume = Fixed Costs + Target Profit (before taxes) Contribution Margin Per Unit

Target Profit Analysis (Before and After Tax) Multiple product formula to reach a target profit: Sales Volume = Fixed Costs + Target Profit Weighted-Average Contribution Margin Per Unit

Target Profit Analysis (Before and After Tax) ABC formula to reach a target profit: Sales (units) = Fixed Costs + Batch-Level Costs + Product-Level Costs + Target Profit Weighted-Average Contribution Margin Per Unit

The Impact of Taxes If After-Tax Profit = Before-Tax Profit (1-tax rate) then Before-Tax Profit = After-Tax Profit / (1-tax rate) Therefore, to determine after-tax Target Profit Fixed Costs + After-Tax Profit / (1-Tax Rate) Contribution Margin per Unit Sales in units =

The Impact of Taxes Key Concept The payment of income tax is an important variable in target profit and other CVP decisions.

Assumptions of CVP Analysis Selling price is constant throughout the relevant range. Costs are linear throughout the relevant range. The sales mix used to calculate the weighted average contribution margin is constant. The amount of inventory is constant.

Cost Structure and Operating Leverage Operating Leverage: 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.

Cost Structure and Operating Leverage Contribution Margin Net Income Operating Leverage = Operating Leverage X % Increase in Sales = % Increase in Net Income

Cost Structure and Operating Leverage Company B 500 1,000 2,000 Sales Cont. Margin Net Income $100,000 $ 60,000 $ 20,000 $200,000 $120,000 $ 80,000 $400,000 $240,000 $200,000 Operating Leverage $60,000 $20,000 $120,000 $80,000 $240,000 $200,000 3.0 1.5 1.2 10% Increase in Sales 30% 15% 12%

Cost Structure and Operating Leverage Key Concept A company operating near the break-even point will have a high level of operating leverage and income will be very sensitive to changes in sales volume.