Chapter 5 Cost-Volume-Profit Relationships

Uses for CVP Analysis Income and profitability –Costs, revenues and income Investment profitability –Current expenditure v. long term profit Pro-forma financial statements Other specialized modeling –Complex sales or demand forecasting

Cost Volume Profit Inputs Basic Cost Volume Profit (CVP) Analysis uses: –Sales levels –Unit sales price –Unit variable cost –Total fixed cost All of these might be: historical, budgeted, projected, hypothetical, etc.

Cost-Volume-Profit Models Relate income and Sales volume Breakeven Analysis –Special instance of cost volume profit –Income is exactly zero –Cautions Can be discussed in units or dollars Multiple products must assume a sales mix

Breakeven based on contribution margin Contribution margin is Sales – Var. Costs Amount that the sale “contributes” to profit –How much higher income is due to this sale For a profit, total contribution margin must exceed fixed costs Breakeven is the # of units where total contribution margin = fixed costs.

Breakeven by Equations Income = Sales revenue – costs Income = Sales revenue – var. costs – fixed costs Income = Price x vol. – var. costs – fixed costs Income = Price x vol. – (Var/unit x volume) – fixed costs Income = (Price – var.) x volume – fixed costs Income = (CM/unit) x volume – fixed costs Thus, if income is zero: 0 = (CM/unit) x volume – fixed costs (CM/unit) x volume = fixed costs or: fixed costs = Vol CM/unit

Breakeven Fixed costs = Breakeven volume CM/unit Example: Fixed costs: $40,000 Sales price: $12/unit Var. costs: $10/unit $40,000 = 20,000 units breakeven point $2/unit

Target Income Breakeven is target income of zero Adding target income to fixed costs will lead to volume to achieve target income From prior slide, for income of $25,000: $25, ,000 = 32,500 units $2/unit

Contribution Margin Percentage What percent of each sales dollar is contribution margin? From Text Example: Sales price = $250 Contribution Margin = $100 $100/$250 = 40%

Contribution Margin in Dollars $Sales to breakeven = Fixed Expenses CM Percentage =$35,000 = $87,500 40%

Breakeven by Dollars Use for companies with many products The dollar is the “unit” Thus, CM per “unit” = CM per dollar CM %age = CM per dollar Then, as before Fixed costs = BE CM/ unit Remember “unit” is sales dollar

Contribution Margin on Dollars Sales2,000,000 VC 700,000 FC600,000 CM = 2,000, ,000 = 1,300,000 1,300,000/2,000,000= CM ratio=.65 CM per sales $ = $.65, thus for B/E: $600,000 = $923,076.65

Operating Leverage Relates contribution margin to income Can measure “downside risk” of not meeting expected income levels Companies with high fixed costs  –High operating leverage –Low var. costs  high Cm/unit –Changes in CM = change in income Investing in fixed assets often increase upside income potential, but higher operating leverage

Operating Leverage Degree of op. lev. + Contribution Margin Net operating income High operating leverage comes from relatively high fixed costs

Multiple Products/Sales Mix Multiple products complicates breakeven/profitability analysis Must assume a mix or alternate mix Different real-world ability to alter the sales mix. 2 Approaches: –weighted-average contribution margin –Compute contribution margin ratio (text)

Weighted average contribution margin CM per unit for each product, times that product’s percentage of sales Leads to Breakeven volume in Units Must then apply the percentages to get number and dollars of each product

Multiple Product Contribution Margin Example Sell two models of skis: –Expert: CM = $200 –Intermediate: CM =$150 Sales Mix: 30% expert/70% intermed. Weighted Ave. Contrib. Margin: $200*(.3) + $150 *(.7)= = $165 If FC = 500, ,000/165 = 3030 pairs of skis

Multiple Product Contribution Margin Example (cont.) Sell 3030 skis to break even Sales mix: 30% expert, 70% intermed. Mix: –3030 x 30% = 909 expert –3030 x 70% = 2121 intermediate 3030 total 3030 is B/E only at this sales mix How would change in mix affect B/E?