Dr Irena JindrichovskaCVP Analysis1 V. Cost-Volume-Profit Analysis The rationale Short run nature of CVP analysis –Time frame during which the company management cannot change the effect of certain past decisions –In practice – less than one year approx. Common cost behaviour patterns –Fixed costs –Variable costs –Mixed costs (semivariable) –Step costs

Dr Irena JindrichovskaCVP Analysis2 Costs patterns Fixed - stay constant over some relevant range of output. Variable – vary (in total) directly with changes in volume of production or sales. Mixed – fixed and variable portion: eg electrical service – fixed when idle, variable when production volume rises. Step costs – supervisors salaries when additional supervisor is hired. Curvilinear nature, linear in relevant range

Dr Irena JindrichovskaCVP Analysis3 Estimating costs in process costing Scattergraph – plots actual level of costs per various level of activity Hi-Low method – uses just the highest and the lowest values – less precise Regression analysis - fits line within observation. Estimates are valid in relevant range only!

Dr Irena JindrichovskaCVP Analysis4 Contribution margin The amount by which the revenue exceeds variable costs of producing that revenue. Per unit or in total sales volume basis Eg. “Video products”

Dr Irena JindrichovskaCVP Analysis5 Break even point Is the number of units the company must sell and earn profit in order not to incur a loss Margin of safety (higher than BEP) Contribution margin x= SP-VC BEP = F / SP – VC –F fixed costs –SP selling price –VC variable costs

Dr Irena JindrichovskaCVP Analysis6 Contribution margin ratio Cont.margin ratio = Cont.margin/sales or Q * (SP-VC)/ Q * SP –SP-selling price –VC – variable cost per unit –Q – quantity of units produced/sold To calculate BEP in dollars: –BEP dollars = Fixed costs/ contribution margin ratio Used in multi-products companies (eg Multi- product)

Dr Irena JindrichovskaCVP Analysis7 Assumptions in C-V-P analysis Cost can be accurately separated into their fixed and variable components Fixed cost remains fixed and variable cost per unit remains constant In multi-product companies production mix remains the same. C-V-P is a useful tool in “what if” analysis

Dr Irena JindrichovskaCVP Analysis8 Operating leverage Magnitude of fixed versus magnitude of variable costs in a firm cost structure High fixed costs – high operating leverage Level of operating leverage affects the change in profit when sales change –The greater the leverage the higher the decrease or increase of profit Concept of Financial leverage and the correspondence

Dr Irena JindrichovskaCVP Analysis9 Degree of operating leverage (DOL) Change in EBIT compared to Change in sales DOL = Q(SP-VC)/(Q(SP-VC)-F) –Q quantity of product units produced and sold –SP selling price per unit –VC variable costs per unit –F fixed costs (per period) Relation to the risk of corporation Degree of operating leverage and degree of financial leverage - correspondence

Dr Irena JindrichovskaCVP Analysis10 Discussion questions 1.Explain and describe behaviour cost patterns 2.Separate mixed costs into fixed and variable components using the scatter diagram and high- low method 3.Clarify the concept of relevant range 4.Explain the relation among costs, volume, revenue and profits 5.Explain break-even point and how you find that.

Dr Irena JindrichovskaCVP Analysis11 Discussion questions 2 6.Explain the concept margin of safety 7.List and explain the assumptions underlying cost volume profit analysis 8.Explain how computer spreadsheets expand your capability to use cost volume profit analysis 9.Explain the impact of automation on fixed variable cost relationship

Dr Irena JindrichovskaCVP Analysis12 Discussion questions 3 A. Using the following data, calculate the sales revenue needed to break even: 1.Selling price per unit: $10 2.Fixed costs$ Variable costs per unit$ 6 B. Using the following data, calculate the contribution margin 1.Selling price per unit: $20 2.Fixed costs$ 4 3.Variable costs per unit$ 6