DEVELOPING A BUSINESS PLAN: CHAPTER 3 DEVELOPING A BUSINESS PLAN: COST-VOLUME-PROFIT ANALYSIS

Chapter Overview Since the future is uncertain and circumstances are likely to change, why should a company bother to plan? What should a company include in its business plan? How does accounting information contribute to the planning process? What must decision makers be able to predict in order to estimate profit at a given sales volume?

Chapter Overview How can decision makers predict the sales volume necessary for estimated revenues to cover estimated costs? How can decision makers predict the sales volume necessary to achieve a target profit? How can decision makers use accounting information to evaluate alternative plans?

Planning in a New Company Planning is an ongoing process for successful companies. A business plan is an evolving report that describes a company’s goals and its current plans for achieving these goals. A business plan is used by both internal and external users.

The Business Plan A business plan typically includes: A description of the company, A marketing plan, A description of the operations of the company, and, A financial plan.

The Financial Plan A major component of a company’s business plan is the financial plan. The purpose of this plan is to identify the company’s capital requirements, sources of capital, as well as to describe the company’s projected financial performance.

Sources of Capital Short-term capital represents those resources raised by the business that will be repaid within a year or less. Examples include buying inventory on credit from a supplier or acquiring a line of credit from the bank that allows a company to borrow money “as needed.”

Sources of Capital Long-term capital represents resources raised by the business from investors or creditors which will be repaid or returned in more than a year. Examples include cash investments by owners, selling stock to investors, or arranging long-term financing with a bank.

Projected Financial Performance This section of the financial plan projects how the company will perform under various scenarios. For example, Sweet Temptations might ask “What will our profit be if we sell only 800 boxes of chocolate? How will it change if we sell 1,300 boxes of chocolate?” The financial performance section is supported by cost-volume-profit analysis and budgets.

Cost-Profit-Volume (CVP) Analysis CVP analysis shows how profit will be affected by alternative sales volumes, selling prices, and costs. CVP analysis is based on a simple profit computation that establishes a relationship between revenues and costs. In order to use CVP analysis effectively, decision makers must understand how costs behave at different volume or activity levels.

Fixed Cost Behavior Fixed costs are constant in total for a specific time period; they are not affected by differences in volume during that same period. Fixed costs are depicted by the horizontal straight-line on a graph, indicating that the cost will be the same (fixed) over different volumes levels.

Fixed Cost Behavior Exhibit 3-3 As Sweet Temptation’s sales volume increases, monthly rent remains constant at $1,000 per month.

Variable Cost Behavior Variable costs change in total in a time period in direct proportion to the changes in volume. Because variable costs change in direct proportion to the changes in volume, the cost per unit is constant. Variable costs are depicted by a sloping line on a graph, indicating that the costs will increase or decrease in proportion to different volume levels.

Variable Cost Behavior Exhibit 3-4 As Sweet Temptation’s sales volume increases, variable costs increase proportionately.

Total Cost Behavior Total costs = f + v(X) Total Costs Sales Volume Total costs at any volume are the sum of fixed costs and variable costs at that volume. The CVP equation for total costs = fixed costs (f) + variable costs per unit (v) times the volume (X).

Total Cost Behavior Exhibit 3-5 Assuming Sweet Temptation’s fixed costs are $3,850 and variable costs are $4.50 per unit, total costs = $8,350 at a sales volume of 1,000 units. Total Costs = f + v(X) Total Costs = $3,850 + $4.50 (1,000) Total Costs = $8,350

Revenues - Variable Costs - Fixed Costs = Profit Profit Computations Once the total cost relationship is defined, a company can then project its costs at different levels of sales volume. The equation for computing net income can be expressed in the following format for CVP analysis: Revenues - Variable Costs - Fixed Costs = Profit Total Expenses

Revenues - Variable Costs - Fixed Costs = Profit Break-Even Point Break-even point is the point at which total revenues equal total costs, so there will be no profit or no loss. $7,000 $7,000 $0 Revenues - Variable Costs - Fixed Costs = Profit Total Expenses

Profit Graph for Sweet Temptations Exhibit 3-7

Contribution Margin A key concept in CVP analysis is called “contribution margin.” Contribution margin equals the difference between estimated total sales revenue and estimated total variable costs.

Contribution Margin Using CVP analysis, a $6/unit contribution margin can be interpreted as follows: For every $1 of sales (or increase in sales), a company will earn 60%, or $.60 to contribute to covering fixed costs and operating profit.

Contribution Margin A contribution margin of $6/unit, or 60%, would add $0.60 in operating profit for every additional dollar of sales once fixed costs are covered, as illustrated in the table below. Break-even point

Showing CVP Relationships With an understanding of contribution margin and fixed costs, CVP analysis can be used to project profit at different levels of sales volume, using the profit equation below: Selling price/unit X unit sales volume Variable cost/unit X unit sales volume Total fixed costs Revenues - Variable Costs - Fixed Costs = Profit Total Expenses Profit (for a given sales volume)

Calculating Break-Even Point Assume Sweet Temptations sells boxes of chocolate at $10 per unit. Variable costs are $4.50 per unit and fixed costs are $3,850. How would the break-even point in units be calculated? Unit sales volume = X Fixed costs Contribution margin per unit Simplified, break-even point in units can be defined as: Break-even point in units

Calculating Break-Even Point By inserting the quantities back into the basic CVP equation, proof is obtained that 700 units equals the break-even point:

Calculating a Desired Profit Assume Sweet Temptations sells boxes of chocolate at $10 per unit. Variable costs are $4.50 per unit and fixed costs of $3,850. How many units have to be sold to earn a profit of $110? Unit sales volume = X Fixed costs + Desired profit Contribution margin per unit Simplified, desired profit point in units can be defined as: Target profit in units

Calculating a Desired Profit By inserting the quantities back into the basic CVP equation, proof is obtained that 720 units will generate the desired profit:

Planning with CVP Analysis Using CVP analysis, a company can project the impact on profits by changing variables. Assumption 1: Selling price increases but other costs do not change. Assumption 2: Fixed costs increase but selling price and variable cost do not change. Assumption 3: Variable costs increase but sales and fixed costs do not change.

How would I calculate break-even point if there is an increase in fixed costs? Reflection

Calculating Break-Even Point When Fixed Costs Change Assume Sweet Temptations sells boxes of chocolate at $10 per unit. Variable costs are $4.50 per unit and fixed costs are $3,850. If fixed costs increase by $1,000, how would the break-even point in units be calculated? The change in fixed costs would simply be included in the basic CVP equation New break-even point in units