Cost-Volume-Profit-Analysis Chapter 19 Cost-Volume-Profit-Analysis

Types of Costs The effect of volume of activity on costs Variable costs Fixed costs Mixed costs

Variable Costs Total variable costs change in direct proportion to changes in the volume of activity Volume can be measured in many different ways: Number of units sold Number of units produced Number of miles driven by a delivery vehicle Number of phone calls placed

Total Variable Costs

Fixed Costs Tend to remain the same in amount, regardless of variations in level of activity Total fixed costs do not change, but the fixed cost per event depends on the number of events

Total Fixed Costs & Fixed Costs per Unit

Mixed Costs Have both a fixed and variable component

Mixed Costs

High-Low Method Method to separate mixed costs into variable and fixed components Identify the highest and lowest levels of activity over a period of time STEP 1: Calculate variable cost per unit STEP 2: Calculate total fixed cost STEP 3: Create and use equation to show the behavior of a mixed cost

High-Low Method: Steps 1 and 2 Data Step 1 Step 2

Step 3

Relevant Range Range of volume Outside the relevant range, costs can differ

S19-1: Variable, fixed, and mixed costs Philadelphia Acoustics builds innovative speakers for music and home theater systems. Consider the following costs. Identify the costs as variable (V), fixed (F), or mixed (M). V 1. Units of production depreciation on routers used to cut wood enclosures 2. Wood for speaker enclosures F 3. Patents on crossover relays M 4. Total compensation to salesperson, who receives a salary plus a commission based on meeting sales goals 5. Crossover relays

S19-1: Variable, fixed, and mixed costs Philadelphia Acoustics builds innovative speakers for music and home theater systems. Consider the following costs. Identify the costs as variable (V), fixed (F), or mixed (M). F 6. Straight-line depreciation on manufacturing plant V 7. Grill cloth M 8. Cell phone costs of salesperson (plan includes 1,200 minutes; overseas calls are charged at an average of $0.15 per minute) 9. Glue 10. Quality inspector’s salary

S19-3: Mixed costs—high-low method Martin owns a machine shop. In reviewing his utility bill for the last 12 months, he found that his highest bill of $2,800 occurred in August when his machines worked 1,400 machine hours. His lowest utility bill of $2,600 occurred in December when his machines worked 900 machine hours. Calculate (a) the variable rate per machine hour and (b) Martin’s total fixed utility cost.

S19-3: Mixed costs—high-low method Martin owns a machine shop. In reviewing his utility bill for the last 12 months, he found that his highest bill of $2,800 occurred in August when his machines worked 1,400 machine hours. His lowest utility bill of $2,600 occurred in December when his machines worked 900 machine hours. 2. Show the equation for determining the total utility cost for Martin’s.

S19-3: Mixed costs—high-low method Martin owns a machine shop. In reviewing his utility bill for the last 12 months, he found that his highest bill of $2,800 occurred in August when his machines worked 1,400 machine hours. His lowest utility bill of $2,600 occurred in December when his machines worked 900 machine hours. 3. If Martin’s anticipates using 1,200 machine hours in January, predict his total utility bill using the equation from Requirement 2.

S19-3: Mixed costs—high-low method 4. Draw a graph illustrating your total cost under this plan. Label the axes, and show your costs at 900, 1,200, and 1,400 machine hours.

Basic CVP Analysis Expresses the relationships among costs, volume, and profit or loss Assumptions: Managers can classify each cost as either variable or fixed Only factor that affects total costs is change in volume, which increases variable and mixed costs Fixed costs do not change

Breakeven Point Sales level at which operating income is zero: Total revenues equal total costs (expenses) Two methods to compute breakeven point: Income statement approach Contribution margin approach

Income Statement Approach Express income in equation form and then break it down into its components:

Contribution Margin Approach Shortcut method Called contribution margin because the excess of sales revenue over variable costs contributes to covering fixed costs

Contribution Margin Ratio Ratio of contribution margin to sales revenue Used to compute the breakeven point in terms of sales dollars Contribution margin is equal to: Contribution margin divided by sales revenue yields a percentage

S19-4: Computing breakeven point in sales units Story Park competes with Splash World by providing a variety of rides. Story sells tickets at $50 per person as a one-day entrance fee. Variable costs are $10 per person, and fixed costs are $240,000 per month. 1. Compute the number of tickets Story must sell to break even.

S19-4: Computing breakeven point in sales units Story Park competes with Splash World by providing a variety of rides. Story sells tickets at $50 per person as a one-day entrance fee. Variable costs are $10 per person, and fixed costs are $240,000 per month. 1.Perform a numerical proof to show that your answer is correct.

S19-5: Computing breakeven point in sales dollars Story Park competes with Splash World by providing a variety of rides. Story sells tickets at $50 per person as a one-day entrance fee. Variable costs are $10 per person, and fixed costs are $240,000 per month. 1. Compute Story Park’s contribution margin ratio. Carry your computation to two decimal places. $50 - $10 = $40 $40 ÷ $50 = 0.80 or 80%

S19-5: Computing breakeven point in sales dollars Story Park competes with Splash World by providing a variety of rides. Story sells tickets at $50 per person as a one-day entrance fee. Variable costs are $10 per person, and fixed costs are $240,000 per month. 2. Use the contribution margin ratio CVP formula to determine the sales revenue Story Park needs to break even.

Using CVP to Plan Profits Managers more interested in: Sales level needed to earn a target profit Profits they can expect to earn How many products or service events must be sold to earn a specific operating profit Use either method

Graphing Cost-Volume-Profit Relations Graph provides a picture that shows how changes in the levels of sales will affect profits Four steps: Choose a sales volume and plot the point for total sales revenue at that volume Draw the fixed cost line Draw the total cost line (total costs are the sum of variable costs plus fixed costs) Identify the breakeven point and the areas of operating income and loss

Preparing a CVP Chart 30

Consider the following facts: S19-6: Computing contribution margin, breakeven point, and units to achieve operating income Consider the following facts: A B C Number of units 1,300 3,600 7.500 Sale price per unit $100 $40 $125 Variable costs per unit 40 10 100 Total fixed costs 72,000 60,000 40,000 Target operating income 180,000 75,000 100,000 Calculate: Contribution margin per unit $60 $30 $25 Contribution margin ratio 0,6 0,75 0,2 Breakeven points in units 1.200 2.000 1.600 Breakeven point in sales dollars $120.000 $80.000 $200.000 Units to achieve target operating income 4.200 4.500 5.600

Sensitivity Analysis Predict how changes in sale prices, cost, or volume affect profits “What-if?” analysis Allows managers to see how various business strategies affect profits

Sensitivity Analysis Summary Exhibit 19-6

Margin of Safety Excess of expected sales over breakeven sales Cushion, drop in sales, a company can absorb without incurring a loss Margin of safety in units Margin of safety in dollars

S19-7: Sensitivity analysis of changing sale price and variable costs on breakeven point Story Park competes with Splash World by providing a variety of rides. Story sells tickets at $50 per person as a one-day entrance fee. Variable costs are $10 per person, and fixed costs are $240,000 per month. 1. Suppose Story Park cuts its ticket price from $50 to $40 to increase the number of tickets sold. Compute the new breakeven point in tickets and in sales dollars.

S19-7: Sensitivity analysis of changing sale price and variable costs on breakeven point Story Park competes with Splash World by providing a variety of rides. Story sells tickets at $50 per person as a one-day entrance fee. Variable costs are $10 per person, and fixed costs are $240,000 per month. 2. Ignore the information in Requirement 1. Instead, assume that Story Park increases the variable cost from $10 to $20 per ticket. Compute the new breakeven point in tickets and in sales dollars.

S19-9: Computing margin of safety Story Park competes with Splash World by providing a variety of rides. Story sells tickets at $50 per person as a one-day entrance fee. Variable costs are $10 per person, and fixed costs are $240,000 per month. 1. If Story Park expects to sell 6,200 tickets, compute the margin of safety in tickets and in sales dollars.

Multiple Product Lines Selling prices and variable costs differ for each product Weighted-average contribution margin computed Sales mix provides weights to make up total product sales

Steps for Computing Breakeven Point with Multiple Product Lines To compute breakeven sales in units for multiple products, complete the following three steps: Calculate the weighted-average contribution margin per unit Calculate the breakeven point in units for the “package” of products Calculate the breakeven point in units for each product. Multiply the “package” breakeven point in units by each product’s proportion of the sales mix FINALLY Prove this breakeven point by preparing a contribution margin income statement

S19-10: Calculating weighted-average contribution margin Wet Weekend Swim Park sells individual and family tickets, which include a meal, three beverages, and unlimited use of the swimming pools. Wet Weekend has the following ticket prices and variable costs for 2012: Wet Weekend expects to sell two individual tickets for every four family tickets. Wet Weekend’s total fixed costs are $75,000. 1. Compute the weighted-average contribution margin per ticket. 2. Calculate the total number of tickets Wet Weekend must sell to break even. 3. Calculate the number of individual tickets and the number of family tickets the company must sell to break even. Individual Family Sale price per ticket 30 90 Variable cost per ticket 15 60

S19-10: Calculating weighted-average contribution margin