CHAPTER 4 Cost-Volume-Profit Analysis

 Variable Costs  Fixed Costs  Mixed Costs  Step Costs Common Cost Behavior Patterns

Variable Costs  Costs that change in proportion to changes in volume or activity  At restaurants, food costs vary with the number of customers served  For airlines, fuel costs vary with the number of miles flown  Example  Activity increases by 10%  Cost increases by 10%

Variable Costs

Fixed Costs  Do not change in response to changes in activity level  Typical fixed costs are depreciation, supervisory salaries, and building maintentance  Example  Activity increases by 10%  Costs remain unchanged

Fixed Costs

 Discretionary Fixed Costs  Management can easily change  Advertising, Research and Development  Committed Fixed Costs  Cannot be easily changed  Rent, Insurance

Fixed Costs

Mixed Costs  Contain variable and fixed cost elements  Example  Salesperson with base salary (fixed)  Receives commission on sales (variable)

Mixed Costs

Step Costs  Fixed cost for a specific range  Increases to higher level when upper bound of range is exceeded  Example  Company adds third production shift  Costs increase to include supervisory costs

Step Costs

Direct Labor

Cost Estimation Methods  Account Analysis  Scattergraphs  High-Low Method  Regression Analysis

Account Analysis  Most common approach  Requires professional judgment of management  Management classifies costs as fixed and variable

Account Analysis  Costs are then estimated  Variable cost per unit  Total fixed costs

Account Analysis  Estimates used to find total production costs at various production levels

Scattergraphs  Utilization of cost information from previous periods  Weekly, monthly, or quarterly cost reports  Plot the costs at specific activity levels

Scattergraphs

High-Low Method  Utilization of cost information from previous periods  Connect straight line from lowest activity level to highest activity level

High-Low Method

 Cost Estimations  Variable cost equals the slope of the line  Fixed cost equals the intercept of cost axis  Estimates used to find total production costs at various production levels

Regression Analysis  Statistical technique  Estimates the slope and intercept of a cost equation  Typically spreadsheet programs are utilized

Regression Analysis

The Relevant Range  Limitation of estimates  Accuracy expected only for production levels within range  Difficult to assess costs outside the relevant range

The Relevant Range

Cost-Volume-Profit Analysis  Equation Abbreviations x = Quantity of units produced and sold SP = Selling price per unit VC = Variable cost per unit TFC = Total fixed cost

Cost-Volume-Profit Analysis  The Profit Equation Profit = SP(x) – VC(x) – TFC  Fundamental to CVP analysis

Cost-Volume-Profit Analysis  Break-Even Point  Number of units sold that allow the company to neither a profit nor a loss  $0 = SP(x) – VC(x) – TFC  Margin of Safety  Difference between expected sales and break-even sales

Break-Even Point

Cost-Volume-Profit Analysis  Contribution Margin (CM)  Difference between selling price and variable cost per unit Profit = (SP – VC)(x) – TFC OR Profit = CM per unit(x) - TFC

Cost-Volume-Profit Analysis  Contribution Margin Ratio  Contribution of every sales dollar to covering fixed cost CM Ratio = SP – VC SP  Profit Equation (utilizing CM Ratio) Sales($) = Profit + TFC CM Ratio

Cost-Volume-Profit Analysis  “What If” Analysis  Utilize profit equation to determine impact of managerial decisions  Change in Fixed and Variable Costs  Change in Selling Price

Cost-Volume-Profit Analysis  Taxes in CVP Analysis  Profit Formula without Tax Considerations Before Tax Profit = SP(x) – VC(x) – TFC  Profit Formula with Tax Considerations After Tax Profit = [SP(x) – VC(x) – TFC](1-t)

 Gabby’s Wedding Cakes creates elaborate wedding cakes. Each cake sells for $500. The variable cost of baking the cakes is $200 and the fixed cost per month is $6,000 1.Calculate the break-even point for a month. 2.How many cakes must be sold to earn a monthly profit of $9,000?

 Break-Even Point x = (Profit + TFC) / CM per Unit x = ($0 + $6,000) / $300 x = 20 cakes  What if monthly profit is $9,000? x = ($9,000 + $6,000) / $300 x = 50 cakes

Multiproduct Analysis  Contribution Margin Approach  Used if products are similar  Identify number of units needed to be sold to break even  Calculate weighted average contribution margin based on expected units sold

Multiproduct Analysis  Contribution Margin Ratio Approach  Products are substantially different  Identify dollar amount of sales needed to break even  Calculate total CM Ratio and use to determine break-even point

Assumptions in CVP Analysis  Costs can be accurately separated into fixed and variable components  Fixed costs remain fixed  Variable costs per unit do not change

Operating Leverage  Level of fixed versus variable costs in a company  High level of fixed costs has a high operating leverage  Typically have large fluctuations in profit when sales fluctuate

Outsourcing

Constraints  Constraints on how many items can be produced  Shortage of space, equipment, or labor  Utilize contribution margin per unit to analyze situations

 Rhetorix, Inc. produces stereo speakers. The selling price per pair of speakers is $800. The variable cost of production is $300 and the fixed cost per month is $50, Calculate the contribution margin associated with a pair of speakers. 2.Calculate the contribution margin ratio for Rhetorix associated with a pair of speakers.

 Contribution Margin CM = SP – VC CM = $800 - $300 CM = $500  If the company sells five more speakers than planned, what is the expected effect on profit of selling the additional speakers? Expected Effect = $500 * 5 units = $2,500

 Contribution Margin Ratio CM Ratio = (SP – VC)/SP = ($800 - $300)/$800 = 62.5%  If the company has sales that are $5,000 higher than expected, what is the expected effect on profit? Expected Effect = 62.5% * $5,000 = $3,125

1.At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Contribution Margin per unit is?Contribution Margin a.$65 b.$75 c.$175 d.$30

1.At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Contribution margin per unit is? a.$65 b.$75 c.$175 d.$30

2.At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Break-Even Point is?Break-Even Point a.1,000 units b.1,083 units c.2,000 units d.None of these

2.At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Break-Even Point is? a.1,000 units b.1,083 units c.2,000 units d.None of these

3.At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Expected sales are 4,200 units. The Margin of Safety is?Margin of Safety a.$264,000 b.$384,000 c.$143,000 d.$121,000

3.At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Expected sales are 4,200 units. The Margin of Safety is? a.$264,000 b.$384,000 c.$143,000 d.$121,000

4.At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Expected sales are 4,200 units. What is profit expected to be? Answer here: _________________

4.At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Expected sales are 4,200 units. What is profit expected to be? Answer here: $143,000