Cost-Volume-Profit Analysis

 Identify how changes in volume affect costs.

Variable Fixed Mixed

Minutes Talked Total Long Distance Telephone Bill Total variable costs change when activity changes. Your total long distance telephone bill is based on how many minutes you talk.

Minutes Talked Per Minute Telephone Charge Variable costs per unit do not change as activity increases. The cost per long distance minute talked is constant. For example, 10 cents per minute.

Consider Grand Canyon Railway.  Assume that breakfast costs Grand Canyon Railway $3 per person.  If the railroad carries 2,000 passengers, it will spend $6,000 for breakfast services.

$24 – $18 – $12 – $6 – – Volume (Thousands of passengers) Total Variable Costs (thousands)

Number of Local Calls Monthly Basic Telephone Bill Total fixed costs remain unchanged when activity changes. Your monthly basic telephone bill probably does not change when you make more local calls.

 Contain fixed portion that is incurred even when facility is unused & variable portion that increases with usage.  Example: monthly electric utility charge ◦ Fixed service fee ◦ Variable charge per kilowatt hour used

Total mixed cost Variable Utility Charge Activity (Kilowatt Hours) Total Utility Cost Fixed Monthly Utility Charge

…is a band of volume in which a specific relationship exists between cost and volume.  Outside the relevant range, the cost either increases or decreases.  A fixed cost is fixed only within a given relevant range and a given time span.

Fixed Costs Volume in Units $160,000 – $120,000 – $80,000 – $40, ,000 10,000 15,000 20,000 25,000 –––––– Relevant Range

 Use CVP analysis to compute breakeven point.

 Expenses can be classified as either variable or fixed.  CVP relationships are linear over a wide range of production and sales.  Sales prices, unit variable cost, and total fixed expenses will not vary within the relevant range.

 Volume is the only cost driver.  The relevant range of volume is specified.  Inventory levels will be unchanged.  The sales mix remains unchanged during the period.

Sales - Variable Costs Contribution Margin - Fixed Costs Operating Income

 Luis and Tom manufacture a device that allows users to take a closer look at icebergs from a ship.  The usual price for the device is $100.  Variable costs are $70 per unit.  They receive a proposal from a company in Newfoundland to sell 20,000 units at a price of $85.

 There is sufficient capacity to produce the order.  How do we analyze this situation?  $85 – $70 = $15 contribution margin.  $15 × 20,000 units = $300,000 (total increase in contribution margin)

Sales (20,000 x $85)$1,700,000 Variable costs (20,000 x $70)(1,400,000) Contribution margin$300,000

The unique sales level at which a company earns neither a profit nor incurs a loss. Sales – Variable Costs – Fixed Costs = 0

Let’s look back at Luis and Tom’s manufacturing, assuming that the fixed cost are $90,000.

 Use CVP analysis for profit planning and graph the cost-volume-profit relations

Volume in Units Costs and Revenue in Dollars Total fixed costs Ê Plot total fixed costs on the vertical axis. Total costs Draw the total cost line with a slope equal to the unit variable cost.

Volume in Units Costs and Revenue in Dollars Total fixed costs Total costs Sales Starting at the origin, draw the sales line with a slope equal to the unit sales price. Break- even Point

 What operating income is expected when sales are _____ units?

 Suppose that our business would be content with operating income of _________________.  How many units must be sold?

 Use CVP method to perform sensitivity analysis.

 Suppose that the sales price per device is _____ rather than ____  What is the revised breakeven sales in units?

 Suppose that variable expenses per device are ____ instead of ____  Other factors remain unchanged.

 Suppose that fixed costs increased by $30,000.  What are the new fixed costs?  What is the new breakeven point?

 Excess of expected sales over breakeven sales.

Fixed expense Break even point Profit Loss Break even in units = 1,200,000 Break even in $ = 1,200,000 x 24 = $28,800,000

 Unit contribution margin is replaced with contribution margin for a composite unit.  A composite unit is composed of specific numbers of each product in proportion to the product sales mix.  Sales mix is the ratio of the volumes of the various products.

The resulting break-even formula for composite unit sales is: Break-even point in composite units Fixed costs Contribution margin per composite unit =

A company sells windows and doors. They sell 4 windows for every door.

Step 1: Compute contribution margin per composite unit.

Break-even point in composite units Fixed costs Contribution margin per composite unit = Step 2: Compute break-even point in composite units.

Break-even point in composite units Fixed costs Contribution margin per composite unit = Break-even point in composite units $900,000 $450 per composite unit = Step 2: Compute break-even point in composite units. Break-even point in composite units = 2,000 composite units

Step 3: Determine the number of windows and doors that must be sold to break even.

Step 4: Verify the results.