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Presentation transcript:

1

Cost-Volume-Profit Analysis Chapter 7 2

Learning Objective 1 Calculate the unit contribution margin and the contribution margin ratio 3

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 4

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 If you know or can estimate four of these five components, you can compute the remaining unknown amount 5

CVP Assumptions Change in volume is only factor that affects costs Managers can classify each cost as either variable or fixed These costs are linear throughout relevant range Revenues are linear throughout relevant range Inventory levels will not change The sales mix of products will not change 6

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. 7

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 ................................................. 7,700 Less: Fixed expenses.................................................. (7,000) Operating income...................................................... $ 700 8

Unit Contribution Margin Kay’s e-tail poster example from previous slides Sales price per unit $ 35 - Variable costs per unit (21) Contribution margin per unit $ 14 Now assume sales are 650 units: Contribution margin ( 650 sales X $14) $ 9,100 - Fixed cost (7,000) Operating Income $ 2,100 9

Contribution Margin Ratio Contribution margin ratio = percentage of each sales dollar that is available for covering fixed expenses and generating a profit. Contribution margin ratio Unit contribution margin = $14 Sales price per unit $35 = 40% Contribution margin ratio Contribution margin = $ 7,700 Sales revenue $19,250 = 40% Numbers above are from the Kay’s e-tail poster example on previous slides. 10

S7-1 Bay Cruiseline offers nightly dinner cruises off the coast of Miami, San Francisco, and Seattle. Dinner cruise tickets sell for $50 per passenger. Bay Cruiseline’s variable cost of providing the dinner is $20 per passenger, and the fixed cost of operating the vessels (depreciation, salaries, docking fees, and other expenses) is $210,000 per month. The company’s relevant range extends to 15,000 monthly passengers. a. What is the contribution margin per passenger? Sales revenue (1 passenger)..................................... Less: Variable expenses ............................................ Contribution margin ................................................. 11

S7-1 (continued) b. What is the contribution margin ratio? c. Use the unit contribution margin to project operating income if monthly sales total 10,000 passengers. d. Use the contribution margin ratio to project operating income if monthly sales revenue totals $400,000. Contribution margin ( $400,000 sales X 60%) Fixed cost Operating Income Contribution margin ratio = Unit contribution margin = $ 30 Sales price per unit = $ 50 = ? ? 12

S7-2 Bay Cruiseline offers nightly dinner cruises off the coast of Miami, San Francisco, and Seattle. Dinner cruise tickets sell for $50 per passenger. Bay Cruiseline’s variable cost of providing the dinner is $20 per passenger, and the fixed cost of operating the vessels (depreciation, salaries, docking fees, and other expenses) is $210,000 per month. The company’s relevant range extends to 15,000 monthly passengers. If Bay Cruiseline sells an additional 500 tickets, by what amount will its operating income increase (or operating loss decrease)? Contribution Margin per unit x additional tickets 13

Use CVP analysis to find breakeven points and target profit volumes Learning Objective 2 Use CVP analysis to find breakeven points and target profit volumes 14

Breakeven Point Breakeven point: Sales level at which operating income is zero Fixed expenses = total contribution margin Total sales = total expenses 15

Calculating Breakeven Point Three approaches to calculating breakeven: Income statement approach Shortcut approach using unit contribution margin Shortcut approach using contribution margin ratio 16

Income Statement Approach Contribution Margin Income Statement Sales - Variable Expenses Contribution Margin - Fixed Expenses Operating Income 17

Short-Cut Approach to Calculating Breakeven Using the Unit Contribution Margin Fixed expenses + Operating income Contribution margin per unit Units sold = $7,000 + $0 $14 Units sold = = 500 posters 18

Short-Cut Using the Unit Contribution Margin Ratio Fixed expenses + Operating income Contribution margin ratio Sales in $ = $7,000 + $0 0.40 Sales in $ = = $17,500 19

Finding the Volume Needed for a Target Profit Using Unit CM CVP analysis helps managers determine what they need to sell to earn a target amount of profit. Fixed expenses + Operating income Contribution margin per unit Units sold = $7,000 + $4,900 $14 $11,900 $14 Units sold = = = 850 posters = 850 posters x $35 = $29,750 20

Finding the Volume Needed for a Target Profit Using Ratio CVP analysis helps managers determine what they need to sell to earn a target amount of profit. Fixed exp + Target operating income Contribution margin ratio Units sold = $7,000 + $4,900 0.40 $11,900 0.40 Units sold = = = 29,750 posters 21

S7-3 Use the information from the Bay Cruiseline Data Set to compute the number of dinner cruise tickets it must sell to break even. a. Use the income statement equation approach. ($50 x units) – ($20 x units) - $210,000 = $0 ($50 – $20 ) x units - $210,000 = $0 22

S7-3 (continued) Use the information from the Bay Cruiseline Data Set to compute the number of dinner cruise tickets it must sell to break even. b. Using the shortcut unit contribution margin approach, perform a numerical proof to ensure that your answer is correct. Fixed expenses + Operating income Contribution margin per unit Units sold = ? Units sold = ? Units sold = = ? 23

S7-3 (continued) Use the information from the Bay Cruiseline Data Set to compute the number of dinner cruise tickets it must sell to break even. c. Use your answers from a and b to determine the sales revenue needed to break even. 7,000 units to break even X $50 sales price = ? 24

S7-3 (continued) Use the information from the Bay Cruiseline Data Set to compute the number of dinner cruise tickets it must sell to break even. d. Use the shortcut contribution margin ratio approach to verify the sales revenue needed to break even. Fixed expenses + Operating income Contribution margin ratio Sales in $ = ? Sales in $ = ? Sales in $ = = ? 25

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 26

Preparing a CVP Chart 27

Preparing a CVP Chart Step 2: Draw the fixed cost line $4,000 28

Preparing a CVP Chart Step 3: Draw the total cost line (fixed plus variable) 29

Preparing a CVP Chart Step 4: Identify the breakeven point and the areas of operating income and loss Breakeven point 30

Preparing a CVP Chart Step 5: Mark operating income and operating loss areas on graph Breakeven point Operating Income Operating Loss 31

S7-5 Revenues 32

S7-5 (continued) Fixed Cost 33

S7-5 (continued) Breakeven Point Income Area Total Cost Loss Area 34

Learning Objective 3 Perform sensitivity analysis in response to changing business conditions 35

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 36

What if the Sales Price Changes? Calculate a new unit contribution margin using the new sales price Use the new unit contribution margin to compute breakeven sales in units Use the new unit contribution margin to compute breakeven sales to maintain target profit Using the new breakeven numbers, decide if a change should be made 37

What if Costs Change? Calculate a new unit contribution margin using the new cost Use the new unit contribution margin to compute breakeven sales in units Use the new unit contribution margin to compute breakeven sales to maintain target profit Using the new breakeven numbers, decide if a change should be made 38

What if Fixed Costs Change? Changes in fixed costs do not affect the contribution margin Breakeven point changes because fixed costs change Use the unit contribution margin to compute the new breakeven sales in units Use the unit contribution margin to compute breakeven sales to maintain target profit Using the new breakeven numbers, decide if a change should be made 39

Find breakeven and target profit volumes for multiproduct companies Learning Objective 4 Find breakeven and target profit volumes for multiproduct companies 40

Breakeven in Sales Revenue: Multiproduct Firm Total expected contribution margin: Regular posters (500 x $14) ............................... $ 7,000 Large posters (300 x $30) .................................. $ 9,000 Total expected contribution margin ................. $16,000 Divided by total expected sales revenue: Regular posters (500 x $35) ............................... $17,500 Large posters (300 x $70) .................................... 21,000 Total expected sales ......................................... ÷ $38,500 Contribution margin ratio............................. = 41.558% 41

Breakeven in Sales Revenue: Multiproduct Firm (continued) Fixed expenses + Operating income Contribution margin ratio Units sold = $7,000 + 0 0.41558 $7,000 0.41558 Units sold = = = $16,844 (rounded) 42

Information Technology and Sensitivity Analysis Allows managers to perform a wide array of sensitivity analyses before committing to decisions. Uses Excel spreadsheets to perform sensitivity analyses Allows managers to estimate how one change (or several simultaneous changes) affects business operations Uses spreadsheet software to create CVP graphs 43

S7-9 Regular Cruise Executive Cruise Sales price per ticket $50 $130 Variable expense per passenger $20 $40 Assuming that Bay Cruiseline expects to sell four regular cruises for every executive cruise, compute the weighted-average contribution margin per unit. Sales Mix Calculation Regular Executive Total Sales price per unit ........................ $ 50 $130 Less: Variable cost per unit ........... (20) (40) Contribution margin per unit ........ Sales mix ....................................... Contribution margin ..................... Weighted-average contribution margin per unit ($210/5) ........... 44

S7-9 (continued) Sales Mix Calculation Regular Executive Total Sales price per unit ........................ $ 50 $130 Less: Variable cost per unit ........... (20) (40) Contribution margin per unit ........ Sales mix ....................................... Contribution margin ..................... Weighted-average contribution margin per unit ($210/5) ........... Is it higher or lower than a simple average contribution margin? Why? 45

S7-9 (continued) Fixed expenses + Operating income Sales in $ = Sales Mix Calculation Regular Executive Total Sales price per unit ........................ $ 50 $130 Less: Variable cost per unit ........... (20) (40) Contribution margin per unit ........ Sales mix ....................................... Contribution margin ..................... Weighted-average contribution margin per unit ($210/5) ........... Will this new sales mix cause Bay Cruiseline’s breakeven point to increase or decrease from what it was when it sold only regular cruises? Fixed expenses + Operating income Weighted Average Contribution margin per unit Sales in $ = ? Sales in $ = = 46

What if the Sales Mix Changes? Use the same CVP formula for multiple products. Use the weighted-average contribution margin per unit of all products. Can find the breakeven or the target profit volume in terms of units, or in terms of sales revenue. Sales Mix Calculation Regular Large Product Product Total Sales price per unit ........................ $ 35 $ 70 Less: Variable cost per unit ........... (21) (40) Contribution margin per unit ........ Sales mix ....................................... Contribution margin ..................... Weighted-average contribution margin per unit ($160/8) ........... 47

Determine a firm’s margin of safety and operating leverage Learning Objective 5 Determine a firm’s margin of safety and operating leverage 48

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

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

Margin of Safety Breakeven sales in units Margin of safety in units Expected sales = − = 950 units − 500 units 450 units Breakeven sales Margin of safety in dollars Expected sales = − = $33,250 – $17,500 = $15,750 51

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 $33,250 = 47.4% (rounded) = 52

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 Operating leverage factor = Contribution margin Operating income Operating leverage factor = $13,300 $6,300 = 2.11 (rounded) 53

High Operating Leverage High operating leverage companies have: Higher levels of fixed costs and lower levels of variable costs Higher contribution margin ratios For high operating leverage companies, changes in volume significantly affect operating income, so they face: Higher risk Higher potential for reward Examples include golf courses, hotels, rental car agencies, theme parks, airlines, cruise lines 54

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. 55

End of Chapter 7 56