©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 6 Cost-Volume-Profit Analysis

Cost-volume-profit (CVP) analysis focuses on the following factors: 1.The prices of products or services 2.The volume of products or services produced and sold 3.The per-unit variable costs 4.The total fixed costs 5.The mix of products or services produced Introduction

CVP Analysis Assumptions Major assumptions of CVP analysis include: Selling price is constant throughout the entire relevant range. The amount of inventory is constant. Costs are linear throughout the relevant range. Sales mix to calculate the weighted-average contribution margin is constant

Comparison of Income Statements Sales$1,000 Less: Cost of Goods Sold: Variable Costs$350 Fixed Costs150 Total Cost of Goods Sold$ 500 Gross Profit$ 500 Less: S, G, & A Costs: Variable Costs$ 50 Fixed Costs 250 Total S, G, & A Costs300 Net Operating Income$ 200 Sales$1,000 Less: Variable Costs: Manufacturing Costs $350 S, G, & A Costs50 Total Variable Costs$ 400 Contribution Margin$ 600 Less: Fixed Costs: Manufacturing Costs$150 S, G, & A Costs 250 Total Fixed Costs400 Net Operating Income$ 200 TRADITIONALCONTRIBUTION MARGIN

Contribution Margin Per Unit Happy Daze Game Co. Total Contribution Margin Per unit Sales (8,000 units)$100,000$12.50 Less: Variable Costs72, Contribution Margin$ 28,000$3.50 Less: Fixed Costs35,000 Net Operating Income (Loss)$ (7,000) Contribution margin (per unit) = Contribution margin (in $)/Units sold = $28,000/8,000 = $3.50

Contribution Margin Ratio Contribution Margin (in $) Sales (in $) Happy Daze’s Contribution Margin = $28,000 $100,000 =28% Total Sales (8,000 units)$100,000 Less: Variable Costs72,000 Contribution Margin$ 28,000 Less: Fixed Costs35,000 Net Operating Income (Loss)$ (7,000)

Applying the Contribution Margin Ratio For every dollar change in sales, contribution margin will increase or decrease by the contribution margin ratio multiplied by the increase or decrease in sales dollars. If Sales Decrease 200 units: Sales Dollar Decrease 200 units x $12.50 $2,500 X Contribution Margin Ratio 28% = $700 Decrease in Contribution Margin and Net Operating Income x =

Considering Qualitative Factors Companies must also consider qualitative factors when choosing options that affect its bottom line. What if a less expensive supplier is less reliable or provides inferior quality material? What if reducing labor causes more machine costs, trading variable costs for fixed costs? What if using inexperienced workers causes more defective products? ???? ???? ??

Break-Even Analysis The break-even point is the level of sales at which contribution margin just covers fixed costs and consequently net operating income is equal to zero. Break-Even (units) = Fixed Costs Contribution Margin Per Unit Fixed Costs Contribution Margin Per Unit Break-Even (Sales $) =

Break-Even Graph

Break-Even Calculations for Multiple Products When more than one product is produced and sold, managers must calculate a “weighted average” contribution margin for all products and estimate the sales mix. Break-Even (Units) = Fixed Costs Weighted Average Contribution Margin Per Unit

Relationship between Weighted-Average Contribution Margin and Break-Even Point The Break-Even Point will DECREASE. As Weighted- Average Contribution Margin INCREASES

Target Profit Analysis (Before and After Tax) Sales volume (to reach a target profit before tax) Fixed Cost + Target Profit (before tax) Contribution Margin per Unit =

The Impact of Taxes It is also important to consider the payment of income taxes in the target profit formula. If a company wants to earn $100,000 in target profit after taxes, and has a 35% income tax rate, what must its before-tax target profit be? Before-tax Profit = After-tax Profit (1 – Tax Rate) = $100,000 (1 – 35%) = $153,846 (rounded)

Sales Volume to Reach an After-Tax Target Profit If a company has fixed cost of $35,000, a contribution margin per unit of $3.50, and desires an after-tax profit of $100,000, how many units must it sell? Sales Volume to Reach After-tax Target Profit = Fixed Costs + Before-tax Profit Contribution Margin per Unit = $35,000 + $153,846 $3.50 = 53,956 units

Cost Structure Cost structure refers to the relative proportion of fixed and variable costs in a company. % fixed costs % variable costs

Operating Leverage The measure of the proportion of fixed costs in a company’s cost structure. It is used as an indicator of how sensitive profit is to changes in sales volume. Operating Leverage = Contribution Margin Net Operating Income

End of Chapter 6