Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Cost-Volume-Profit Analysis Chapter 7 1

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 1 Calculate the unit contribution margin and the contribution margin ratio 2

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Cost-Volume-Profit (CVP) Analysis Is a powerful tool that helps managers make important business decisions Is a relationship among costs, volume, and profit or loss Determines how much the company must sell each month just to cover costs or to break even Helps managers decide how sales volume would need to change to achieve the same profit level 3

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Components of CVP Analysis CVP analysis relies on the interdependency of five components, or pieces of information – Sales price per unit – Volume sold – Variable costs per unit – Fixed costs – Operating income 4

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. CVP Assumptions 1.No volume discounts 2.Costs are linear throughout relevant range 3.Revenues are linear in relevant range 4.Inventory levels will not change 5.Sales mix will not change 5

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. CVP Example Facts – Kay’s Posters Kay has an e-tail poster business. She currently sells each poster for $35, while each poster has a variable cost of $21. Kay has fixed costs of $7,000. Kay is currently selling 550 posters. 6

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Contribution Margin Income Statement Kay’s e-tail poster example from prior slide Sales revenue (550 posters) $ 19,250 Less: Variable expenses (11,550) Contribution margin ,700 Less: Fixed expenses (7,000) Operating income $ 700 7

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Unit Contribution Margin 8 Kay’s e-tail poster example from previous slides Now assume sales are 650 units: Sales price per unit $35 - Variable costs per unit (21) Contribution margin per unit $14 Contribution margin (650 sales X $14) $9,100 - Fixed cost (7,000) Operating Income $2,100

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Contribution Margin Ratio Contribution margin ratio= percentage of each sales dollar that is available for covering fixed expenses and generating a profit. Numbers above are from the Kay’s e-tail poster example on previous slides. 9 Contribution margin ratio Unit contribution margin Sales price per unit = $14 $35 = 40% Contribution margin ratio Contribution margin Sales revenue = $ 7,700 $19,250 = 40%

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Now turn to S7-1 10

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. S7-1 a.What is the contribution margin per passenger? Sales revenue (1 passenger) $ 120 Less: Variable expenses (48) Contribution margin $ 72 11

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. S7-1 (cont.) b.What is the contribution margin ratio? c. Use the unit contribution margin to project operating income if monthly sales total 10,000 passengers. 10,000 x $72 = $720,000 – fixed costs of $270,000 = $450,000 d. Use the contribution margin ratio to project operating income if monthly sales revenue totals $650,000. Contribution margin ( $650,000 sales X 60%) $ 390,000 Fixed cost (270,000) Operating income$ 120, Contribution margin ratio = Unit contribution margin Sales price per unit = $72 $120 = 60%

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Now turn to S7-2 13

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. S7-2 If Luxury Cruiseline sells an additional 300 tickets, by what amount will its operating income increase (or operating loss decrease)? Contribution Margin per unit × additional tickets 300 tickets × $72 = $21,600 14

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 2 Use CVP analysis to find breakeven points and target profit volumes 15

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Breakeven Point Breakeven point: Sales level at which operating income is zero – If sales above breakeven, then profit – If sales below breakeven, then loss Fixed expenses = total contribution margin Total sales = total expenses 16

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Using Unit Contribution Margin to Calculate Breakeven Point in Units 17 Fixed expenses + Operating income Contribution margin per unit Units sold = $7,000 + $0 $14 Units sold = = 500 posters

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Using Contribution Margin Ratio to Calculate Breakeven Point in Sales Dollars 18 Fixed expenses + Operating income Contribution margin ratio Sales in $ = $7,000 + $ Sales in $ = = $17,500

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Finding Volume Needed for Target Profit Using Unit CM 19 Fixed expenses + Operating income Contribution margin per unit Units to be sold = = 850 posters $7,000 + $4,900 $14 Units to be sold = = $11,900 $14 = 850 posters × $35 = $29,750 (Sales $ needed to achieve target profit)

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Finding the Volume Needed for a Target Profit Using CM Ratio CVP analysis helps managers determine what they need to sell to earn a target amount of profit 20 Fixed exp + Target operating income Contribution margin ratio Sales $ needed = = $29,750 $7,000 + $4, Sales $ needed = $11, =

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Now turn to S7-3 21

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. S7-3 Breakeven number of passengers: 22 Fixed expenses + Operating income Contribution margin per unit Units to be sold = $270,000 + $0 $72 Units to be sold = = 3,750 passengers $270,000 $72 Units to be sold =

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. S7-3 (cont.) 23 Fixed expenses + Operating income Contribution margin ratio* Sales in $ = $270, Sales in $ = = $450,000 Sales revenue needed to break even: 3,750 units to breakeven × $120 sales price = $450,000 Alternatively: *CM ratio = $72/ $120 =.60

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Graphing the CVP Relationships Step 1: – Choose a sales volume (Units x $Price) – Plot point for total sales revenue – Draw sales revenue line from origin through the plotted point 24

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Preparing a CVP Chart 25

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Preparing a CVP Chart Step 2: – Draw the fixed cost line 26 $4,000

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Preparing a CVP Chart Step 3: – Draw the total cost line (fixed plus variable) 27

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Preparing a CVP Chart Step 4: – Identify the breakeven point and the areas of operating income and loss Breakevenpoint 28

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Preparing a CVP Chart Step 5: – Mark operating income and operating loss areas on graph Operating Loss Operating Income Breakeven point Operating Income Operating Loss 29

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 3 Perform sensitivity analysis in response to changing business conditions 30

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Sensitivity Analysis Managers need to be prepared for increasing costs, pricing pressure from competitors, and other changing business conditions. Sensitivity analysis Conducts “What if” analysis – What if the sales price changes? – What if costs change? – What if the sales mix changes? 31

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. What if the sales price changes? Contribution margin will change Breakeven point will change 32

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. What if variable costs change? Contribution margin changes Breakeven point changes 33

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. What if fixed costs change? Will not affect contribution margin Will change breakeven point 34

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Sustainability and CVP Reducing costs and helping the environment For example, decreasing use of plastic in bottles reduces Variable Costs Decreasing Variable Costs makes it easier to reach a target profit 35

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 4 Find breakeven and target profit volumes for multiproduct companies 36

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Breakeven in Sales Revenue – Multiproduct Firm Example, Exhibit

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Breakeven in Sales Revenue – Multiproduct Firm Example (cont.) 38 Fixed expenses + Operating income Weighted-avg contribution margin per unit Units sold = = 350 posters Units sold = = $7,000 $20 $7, $20

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Breakeven in Sales Revenue – Multiproduct Firm Example (cont.) 39 Breakeven sales of regular posters (350 x 5/8) regular posters Breakeven sales of large posters (350 x 3/8) large posters Since partial posters cannot be sold, the number of each to be sold is rounded UP (to avoid a loss)

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Now turn to S7-9 40

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. S7-9 Assuming that Luxury Cruiseline expects to sell four regular cruises for every executive cruise, compute the weighted-average contribution margin per unit. 41 Sales Mix Calculation Regular ExecutiveTotal Sales price per unit $ 120 $240 Less: Variable cost per unit (48) (180) Contribution margin per unit $ 72 $ 60 Sales mix x 4 x 1 5 Contribution margin $288 $ 60 $348 Weighted-average contribution margin per unit ($348/5) $ 69.60

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Now turn to S

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. S Fixed expenses + Operating income Weighted Average Contribution margin per unit Sales in units = $270, $69.60* Sales in units = = 3,880 tickets *from S7-9 on prior slide Breakeven sales of regular cruises (3,880 × 4/5)………3,104 Breakeven sales of executive cruises (3,880 × 1/5) Total cruise passengers ………..3,880

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Now turn to E7-28A 44

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. 45 E7-28A Step 1: Calculate weighted-average contribution margin Twig Oak Sale price per unit$18$38 Variable costs per unit 3 8 Contribution margin per unit$15$30 Sales mix in unitsx4x1 Contribution margin$60$30 Weighted average contribution$90 Margin per unit ($90 /5)$18

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E7-28A (cont.) Step 2: Calculate the breakeven point in units Fixed costs + Operating income Weighted average contribution margin per unit ($360 + $0) ÷ $18 = 20 composite units 46

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E7-28A (cont.) Step 3: Calculate the breakeven point in units for each product line Twig Stands: 20 units x 4/5 = 16 units Oak Stands: 20 units x 1/5 = 4 units 47

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 5 Determine a firm’s margin of safety and operating leverage 48

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Common Indicators of Risk Margin of Safety – The excess of expected sales over breakeven sales Operating Leverage – The relative amount of fixed and variable costs that make up a company’s total costs 49

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Margin of Safety Excess of expected sales over breakeven sales Drop in sales that the company can absorb before incurring a loss Used to evaluate the risk of current operations as well as the risk of new plans 50

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Margin of Safety -- Units and Sales Dollars -- Example Margin of safety in units = Expected sales in units _ Breakeven sales in units =950 units _ 500 units = 450 units Margin of safety in dollars =Expected sales _ Breakeven sales =$33,250 _ $17,500 =$15,750 51

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Margin of Safety – Percentage -- Example 52 Margin of safety as a percentage Margin of safety in units Expected sales in units = 450 Units 950 Units = 47.4% (rounded) = Margin of safety as a percentage Margin of safety in dollars Expected sales in dollars = = $15,750 $33, % (rounded) =

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Now turn to S

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. S7-13 (cont.) Margin of safety in units = Expected sales in units _ Breakeven sales in units =1,000 units _ 600 units = 400 units Margin of safety in dollars =Expected sales _ Breakeven sales =$31,000 _ $18,600 =$12, a. b.

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. S7-13 (cont.) 55 Margin of safety as a percentage Margin of safety in dollars Expected sales in dollars = = $12,400 $31,000 40% = c.

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Operating Leverage Factor How responsive a company’s operating income is to changes in volume – Lowest possible value for this factor is 1, if the company has no fixed costs 56 Operating leverage factor= Contribution margin Operating income Operating leverage factor= $13,300 =1.00

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Operating Leverage Factor – Change in Fixed Costs How responsive a company’s operating income is to changes in volume – Lowest possible value for this factor is 1, if the company has no fixed costs 57 Operating leverage factor= Contribution margin Operating income Operating leverage factor= $13,300 $6,300 = 2.11 (rounded)

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. High Operating Leverage High operating leverage companies have: – Higher levels of fixed costs and lower levels of variable costs – Higher contribution margin ratios – Higher risk – Higher potential for reward 58

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Low Operating Leverage Low operating leverage companies have: – Higher levels of variable costs and lower levels of fixed costs – Lower contribution margin ratios For low operating leverage companies, changes in volume do NOT have as significant an effect on operating income, so they face: – Lower risk – Lower potential for reward Examples include merchandising companies. 59

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Now turn to S

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. S7-14 (cont.) 61 Contribution margin (1,000 × $10 / poster)…….$10,000 Less:Fixed expenses…………………………. (6,000) Operating income………………………………..$ 4,000 Operating Leverage Factor = Contribution margin Operating income = $10,000 $ 4,000 =2.5 If volume increases 10%, operating income will increase 25% (operating leverage factor of 2.5 multiplied by 10.)

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. S7-14 (cont.) 62 Original volume (posters)…………………………..1,000 Add:Increase in volume (10% × 1,000)………+ 100 New volume (posters)……………………………....1,100 Multiplied by:Unit contribution margin………….× $10 New total contribution margin……………………..$ 11,000 Less:Fixed expenses……………………………... (6,000) New operating income……………………………… $ 5,000 vs.Operating income before change in volume (from above)……………………… ,000 Increase in operating income……………………... $ 1,000 Percentage change ($600 / $2,400)…………….. 25% Proof:

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. End of Chapter 7 63