Cost-Volume-Profit Analysis UAA – ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee

2 Introduction We have learned... –How to identify costs as fixed, variable, and mixed; –How each of these behave when changes take place; and –How to separate them into their component parts.

3 Introduction Understanding these relationships help managers to; –Predict future conditions (planning); and –Explain, evaluate, and act on past results (control)

4 Introduction Today we will focus on gaining an understanding of how... –Costs –Volume, and –Profits Interact

5 Cost-Volume-Profit (CVP) CVP is the systematic examination of the relationships among... –Selling prices, –Volume of Sales and Production –Cost, –Expenses, and –Profits

Output Sales Price Variable Costs Fixed Costs Total Revenues Total Cost Operating Income Total Revenue Total Cost Operating Income What happens here? As changes occur here. Graphically 4 Output Sales Price Variable Costs Fixed Costs

7 CVP - For-Profit Firms How many photocopies must the College Avenue Copy Shop produce to earn a profit of $20,000? At what sales volume will Burger King’s total costs and total revenues equal?

8 CVP - For-Profit Firms What will happen to profits in Joe’s Diner if... –There is a 20% increase in the cost of food; and –A 10% increase in the selling price of meals?

9 CVP - Not-For-Profit Firms How many meals can the Salvation Army serve with an annual budget of $150,000? How many tickets must be sold for the benefit concert to raise $15,000?

10 CVP - Not-For-Profit Firms Given current tuition rates and projected enrollments, how much money must UAA obtain from other sources?

11 CVP is Useful in... Choice of product lines Pricing of products Developing marketing strategies Utilization of productive facilities

12 Traditional Statement Costs are grouped by functional classifications - such as: –Production, –Selling & Administration With both fixed and variable costs being included in each category.

Sales$xxx COGS(xx) Gross Margin$xxx Selling Exp.(xx) Net Income $xxx Admin. Exp(xx) Production FC & VC Selling FC & VC Administrative FC & VC

14 Contribution Format The focus of the contribution format income statement is the contribution margin... Contribution Margin = Net Sales - Variable Costs

15 Contribution Format I/S Groups costs by behavior: –Fixed, and –Variable Rather than into the functional categories of production, marketing and administration.

Sales$xxx Variable Costs(xx) Cont. Margin$xxx Fixed Costs(xx) Net Income $xxx

Income Statements... Sales$xxx COGS(xx) Gross Margin$xxx Operating Exp(xx) TraditionalContribution Format Net Income $xxx Sales$xxx Variable Costs(xx) Cont. Margin$xxx Fixed Costs(xx) Net Income $xxx

Sourdough Alaska, Inc. Sales $900,000 Cost of Sales Direct Materials $100,000 Direct Labor 160,000 Mfg. Overhead 100, ,000 VC=$55,000 FC=$45,000 Marketing Costs Variable 18,000 Fixed 82, ,000 Admin. Costs (Fixed) $150,000

Sourdough Alaska, Inc. Traditional Income Statement For Year Ended December 31, 2001 Sourdough Alaska, Inc. Traditional Income Statement For Year Ended December 31, 2001 Sales $900, % Cost of Sales Direct Materials $100,000 Direct Labor 160,000 Mfg. Overhead 100, ,000 40% Gross Margin $540,000 60% Marketing/Admin Costs Marketing Costs $100,000 Administrative Costs 150, ,000 Net Income $290,000

Sourdough Alaska, Inc. Traditional Income Statement For Year Ended December 31, 2001 Sourdough Alaska, Inc. Traditional Income Statement For Year Ended December 31, 2001 Sales $900, % Cost of Sales Direct Materials $100,000 Direct Labor 160,000 Mfg. Overhead 100, ,000 40% Gross Margin $540,000 60% Marketing/Admin Costs Marketing Costs $100,000 Administrative Costs 150, ,000 Net Income $290,000 Note functional grouping of costs

21 What if... You were asked to project the effect on net income of: –A 20% increase in sales volume; –With no change in selling prices. How would you go about doing it?

Sourdough Alaska, Inc. Traditional Income Statement For Year Ended December 31, 2001 Sourdough Alaska, Inc. Traditional Income Statement For Year Ended December 31, 2001 Sales $900, % Cost of Sales Direct Materials $100,000 Direct Labor 160,000 Mfg. Overhead 100, ,000 40% Gross Margin $540,000 60% Marketing/Admin Costs Marketing Costs $100,000 Administrative Costs 150, ,000 Net Income $290,000 Includes: $55,000 VC $45,000 FC Includes: $18,000 VC $82,000 FC All Fixed

Sourdough Alaska, Inc. Contribution Format Income Statement For Year Ended December 31, 2001 Sourdough Alaska, Inc. Contribution Format Income Statement For Year Ended December 31, 2001 Sales $900, % Cost of Sales Direct Materials $100,000 Direct Labor 160,000 Mfg. Overhead 55,000 Variable Mkt. Exp 18,000 $333,000 37% Contribution Martin $567,000 63% Fixed Costs Manufacturing 45,000 Marketing 82,000 Administrative 150, ,000 Net Income $290,000

Sourdough Alaska, Inc. Contribution Format Income Statement For Year Ended December 31, 2001 Sourdough Alaska, Inc. Contribution Format Income Statement For Year Ended December 31, 2001 Sales $900, % Cost of Sales Direct Materials $100,000 Direct Labor 160,000 Mfg. Overhead 55,000 Variable Mkt. Exp 18,000 $333,000 37% Contribution Martin $567,000 63% Fixed Costs Manufacturing 45,000 Marketing 82,000 Administrative 150, ,000 Net Income $290,000 Now, costs are grouped by BEHAVIOR

25 NOW... What if... You were asked to project the effect on net income of: –A 20% increase in sales volume; –With no change in selling prices. How would you go about doing it?

Sourdough Alaska, Inc. Projected Increase in Net Income For Year Ended December 31, 2001 Sourdough Alaska, Inc. Projected Increase in Net Income For Year Ended December 31, 2001 Sales ($900,000 x 120%) $1,080,000 Contribution Margin 688,400 Projected Net Income 403,400 Less: VC: ($333,000 x 120%) 399,600 Less: Fixed Costs 277,000 Less 1997 Net Income 290,000 Projected Increase in Net Income $113,400

Sourdough Alaska, Inc. Projected Increase in Net Income For Year Ended December 31, 2001 Sourdough Alaska, Inc. Projected Increase in Net Income For Year Ended December 31, 2001 Sales ($900,000 x 120%) $1,080,000 Contribution Margin 688,400 Projected Net Income 403,400 Less: VC: ($333,000 x 120%) 399,600 Less: Fixed Costs 277,000 Less 1997 Net Income 290,000 Projected Increase in Net Income $113,400

Is this stuff usable?

Break-Even Analysis

The Equation Method Exhaustion Unlimited – An Illustration

Per BikePercent SP$500100% VC30060% CM$20040% Fixed Costs = $80,000

Per BikePercent SP$500100% VC30060% CM$20040% Fixed Costs = $80,000 Use this info to get the BEP in # of units.

The equation method centers on the contribution approach to the income statement. Sales$xxx Variable Costs(xx) Contribution Margin$xxx Fixed Costs(xx) Net Income $xxx

At breakeven profit = 0  The equation becomes:

Use our BE Equation; and Let X = BE Point in Bikes Sales = VC + FC $500X = $300X + $80,000 $200X = $80,000 X = 400 Bikes Sales FCVC

Per BikePercent SP$500100% VC30060% CM$20040% Fixed Costs = $80,000 Use this info to get the BEP in Sales $$$ CMR

Use our BE Equation; and Let X = BE Point in Sales $ Sales = VC + FC 1X =.6X + $80,000.4X = $80,000 X = $200,000 Sales FCVC

The Equation Method OK... But Does It Work?

Exhaustion Unlimited Income Statement For Year Ended 12/31/01 Sales (400 x $500)$200,000 VC (400 x $300)120,000 CM$80,000 FC80,000 Net Income$-0-

Break-Even Analysis The Unit-Contribution Method

41 Unit-Contribution Method Is a variation of the equation method. The method may be just a bit more intuitive than the equation method.

42 The approach centers on the idea that each unit sold provides a certain amount of CM that goes toward covering fixed costs. Unit-Contribution Method

43 The Formula... Unit-Contribution Method Fixed Expenses =BEP Unit Contribution Margin

Per Bike % SP$500100% VC30060% CM$20040% FC are $80,000 Use this info to get the BEP in # of units.

Fixed Costs Unit CM BEP in Units

Per Bike % SP$500100% VC30060% CM$20040% FC are $80,000 Use this info to get the BEP in Sales $$$

Fixed Costs CM % BEP in $

48 Unit Contribution Method Let’s look at a series of income statements that graphically point out the concept of a contribution margin.

Exhaustion Unlimited Income Statement 1 Bike2 Bikes400 Bikes401 Bikes Sales$500$1,000$200,000$200,500 VC ,000$120,300 CM$200$400$80,000$80,200 FC80,000 NI($79,800)($79,600)$-0-$200

Break-Even Analysis Target Net Profit Analysis

51 Target Net Profit Analysis A firm’s targeted NI is the amount of income the firm wishes to make... –Pre-Tax OI; or –After-Tax NI

52 Target Net Profit Analysis Recall the BE formula:

53 Target Net Profit Analysis Using data from Exhaustion Unlimited. Assume the firm wants to make a before-tax profit of $40,000.

Per BikePercent SP$500100% VC30060% CM$20040% Fixed Costs = $80,000

Per BikePercent SP$500100% VC30060% CM$20040% Fixed Costs = $80,000 Use this info to get the BEP in # of units.

Use our BE Equation; and Let X = BE Point in Bikes Sales = VC + FC + Profits $500X = $300X + $80,000 + $40,000 $200X = $120,000 X = 600 Bikes Sales FCVC Desired Profit

Per BikePercent SP$500100% VC30060% CM$20040% Fixed Costs = $80,000 Use this info to get the BEP in Sales $$$ CMR

Use our BE Equation; and Let X = BE Point in Sales $ Sales = VC + FC + Profits 1X =.6X + $80,000 + $40,000.4X = $12,000 X = $300,000 Sales FCVC Desired Profit

Exhaustion Unlimited Income Statement For Year Ended 12/31/01 Sales (600 x $500)$300,000 VC (600 x $300)180,000 CM$120,000 FC80,000 Net Income$40,000

Target Before-Tax Profit Analysis The Unit Contribution Method

61 The Formula... Unit-Contribution Method Fixed Expenses =BEP Unit Contribution Margin Add Targeted Before-Tax OI (TI) to the Fixed Expenses Fixed Expenses +TI =BEP Unit Contribution Margin Add Targeted Before-Tax OI (TI) to the Fixed Expenses

Fixed Costs Unit CM BEP in Units Desired BT OI (TI)

Fixed Costs CM % BEP in $ Desired BT OI

Target Net Profit Analysis What About Taxes?

 The equation becomes: Remember this? Profit means taxes At breakeven profit = 0

66 Tax Effects...

67 Net Income OI = (1 – TR) This, then, is our handy-dandy formula to calculate an after- tax net income (ATNI).

Taxes and Break-Even Sales Let’s Just Do It!

69 Target Net Profit Analysis Back to Exhaustion Unlimited Assume management wants $40,000 after taxes Tax Rate = 30%

Sales = VC + FC + ATNI SalesFC VC Targeted ATNI

Sales = VC + FC + ATNI Bikes

CVP Analysis Some Limiting Assumptions

74 Limiting Assumptions CVP assumes a linear revenue and cost function. CVP analysis assumes a relevant range. CVP assumes that production equals sales.

75 Limiting Assumptions Sales mix remains constant. Sales prices and costs are known with certainty.