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Cost-Volume-Profit Analysis and Planning

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1 Cost-Volume-Profit Analysis and Planning
Module 16 Cost-Volume-Profit Analysis and Planning © Cambridge Business Publishers, 2018

2 1 Describe the uses and limitations of traditional cost-volume-profit analysis. © Cambridge Business Publishers, 2018

3 Profitability Analysis
Involves examining the relationships among revenues, costs, and profits Widely used in the economic evaluation of existing or proposed products or services Performed before decisions are finalized What you need to understand to perform profitability analysis Selling prices Behavior of activity cost drivers © Cambridge Business Publishers, 2018

4 Cost-Volume-Profit Analysis
CVP A technique to examine the relationships among total volume of an independent variable, total costs, total revenues, and profits for a time period. Useful in the early stages of planning Provides an easily understood framework for discussing planning issues and organizing relevant data © Cambridge Business Publishers, 2018

5 CVP Use in For-Profit Companies
Provides answers to questions such as… How many cappuccinos must Starbucks sell to earn total profit of $50,000? At what sales volume will McDonald’s total revenues and total costs be equal? What profit will Office Max earn at sales volume of $200 million? What will happen to Disney’s profit if ticket selling prices are increased by 10% and fixed costs increase by 8%? © Cambridge Business Publishers, 2018

6 CVP Use in Not-For-Profit Companies
Used by not-for-profit entities to… Establish service levels Plan fund-raising events Determine funding requirements Answers questions such as… How many homeless people can the Homeless Center house with a budget of $400,000? How much money must be raised from alumni at Princeton to provide 50 full scholarships? © Cambridge Business Publishers, 2018

7 CVP Assumptions All costs are classified as fixed or variable.
The total cost function is linear within the relevant range. The total revenue function is linear within the relevant range. The analysis is for a single product, or the sales mix of multiple products is constant. There is only one activity cost driver: unit or dollar sales volume. Accuracy decreases as the scope of operations being analyzed increases. © Cambridge Business Publishers, 2018

8  = R – Y R = pX Y = a + bX The Profit Formula
Profit () of a product, service or event = Total revenues (R) minus total costs (Y):  = R – Y Revenues (R) are a function of unit sales volume (X) and unit selling price (p): R = pX Total costs for a time period (Y) are a function of fixed costs per period (a) and unit variable costs (b): Y = a + bX © Cambridge Business Publishers, 2018

9 Expanded Profit Formula
The expanded profit formula is: π = pX – (a + bX) Used to predict profit at any specified activity level, represented by X. © Cambridge Business Publishers, 2018

10 Using the Profit Formula
To use the profit formula Separate all the company’s costs into variable and fixed components Nature of costs Variable Costs The cost of the primary raw materials converted into finished goods Direct Materials Wages earned by production employees converting raw materials into finished goods Direct Labor © Cambridge Business Publishers, 2018

11 Variable and Fixed Components
Variable Costs All other variable costs associated with converting raw materials into finished goods Variable manufacturing overhead All variable costs not directly associated with converting raw materials into finished goods Variable selling and administrative costs Fixed Costs All fixed costs associated with converting raw materials into finished goods Fixed manufacturing overhead All fixed costs not directly associated with converting raw materials into finished goods Fixed selling and administrative costs © Cambridge Business Publishers, 2018

12 Example Using the Profit Equation
Chillin’ Time produces and sells one product, ice cream bars, for $1.50 each. To ensure top quality, no inventories are maintained. Estimated costs are: Variable Costs Per Ice Cream Bar Fixed Costs Per Month Manufacturing costs: Manufacturing overhead $1,200 Direct materials $0.43 Selling and administrative 580 Direct labor 0.32 Total $1,780 0.20 $0.95 0.15 $1.10 Profit Formula to earn $1,000 $1,000 = $1.50X - $1,780 - $1.10X X = 6,950 ice cream bars Chillin’ Time must sell 6,950 ice cream bars each month to result in $1,000 profit. © Cambridge Business Publishers, 2018

13 Prepare and contrast contribution and functional income statements.
2 Prepare and contrast contribution and functional income statements. © Cambridge Business Publishers, 2018

14 Income Statement Formats
Contribution Income Statement Functional Income Statement Costs are classified according to behavior Variable Fixed Contribution margin Total revenues less total variable costs Represents the amount that goes toward covering fixed costs and providing a profit Costs are classified according to function Manufacturing Selling and administrative Gross Margin Total revenues less cost of goods sold Represents the amount that goes toward covering other expenses and providing a profit © Cambridge Business Publishers, 2018

15 Contribution Income Statement Example
CHILLIN’ TIME Contribution Income Statement For a Monthly Volume of 6,950 Ice Cream Bars Sales (6,950 x $1.50) $10,425. Less variable costs: Direct materials (6,950 x $0.43) $2,988 Direct labor (6,950 x $0.32) 2,224 Manufacturing overhead (6,950 x $0.20) 1,390 Selling and administrative (6,950 x $0.15) 1,043 (7,645) Contribution margin 2,780. Less fixed costs: Manufacturing 1,200 Selling and administrative 580 (1,780) Profit $ 1,000. © Cambridge Business Publishers, 2018

16 Functional Income Statement Example
CHILLIN’ TIME Functional Income Statement For a Monthly Volume of 6,950 Ice Cream Bars Sales (6,950 x $1.50) $10,425. Less cost of goods sold: Direct materials (6,950 x $0.43) $2,988 Direct labor (6,950 x $0.32) 2,224 Variable manufacturing overhead (6,950 x $0.20) 1,390 Fixed manufacturing overhead 1,200 (7,802) Gross margin 2,623. Less other expenses: Variable selling and administrative (6,950 x $0.15) 1,043 Fixed selling and administrative 580 (1,623) Profit $ 1,000. © Cambridge Business Publishers, 2018

17 Analysis Using Contribution Margin Ratio
Sensitivity analysis How a model responds to changes in one or more independent variables Unit contribution margin Indicates how sensitive and income model is to a change in unit sales Contribution margin The portion of every sales dollar contributed toward covering fixed costs and earning a profit © Cambridge Business Publishers, 2018

18 Contribution Margin Example
Chillin’ Time’s contribution income appears below: Total Per Unit Sales (6,950 units) $ 10,425 $ 1.50 Variable costs (7,645) (1.10) Contribution margin 2,780 Fixed costs (1,780) Profit $ 1,000 Contribution margin per unit $1.50 – $1.10 = $0.40 Contribution margin ratio [$1.50 – $1.10] / $1.50 = © Cambridge Business Publishers, 2018

19 Sensitivity Analysis Example
Total Per Unit Ratio to Sales Sales (6,950 units) $10,425. $ 1.50 1.000 Variable costs (7,645) (1.10) (0.733) Contribution margin 2,780. $ 0.40 0.267 Fixed costs (1,780) Profit $ 1,000. If sales increase by 100 ice cream bars per month, by how much will net income increase? 100 x $0.40 = $40 If sales increase by $1,050 per month, by how much will net income increase? $1,050 x = $280 © Cambridge Business Publishers, 2018

20 3 Apply cost-volume-profit analysis to find a break-even point and for preliminary profit planning. © Cambridge Business Publishers, 2018

21 Break-Even Point Occurs when total revenues equal total costs
Can be unit sales volume, or Dollar sales volume Operating below break-even Company operates at a loss Operating above break-even Company operates at a profit © Cambridge Business Publishers, 2018

22 Break-even unit sales volume
Break-Even Point Break-even unit sales volume Fixed costs Selling price per unit – Variable costs per unit = Fixed costs Unit contribution margin = © Cambridge Business Publishers, 2018

23 Break-Even Point Example
Chillin’ Time sells ice cream bars with a $1.10 unit variable cost for $1.50 each. How many bars must it sell to break even? Fixed costs Unit contribution margin = $1,780 $ $1.10 = = 4,450 units Chillin’ Time’s Break-Even Unit Sales Volume When Chillin’ Time sells 4,450 ice cream bars per month, it will break even. © Cambridge Business Publishers, 2018

24 Profit Planning—Target Profit
If Chillin’ Time wants to earn a monthly profit of $800, how many ice cream bars must it sell? Fixed costs + Desired profit Unit contribution margin = Target unit sales volume $1,780 + $800 $ $1.10 = = 6,450 units Chillin’ Time’s Target Unit Sales Volume When Chillin’ Time sells 6,450 ice cream bars per month, it will generate profit of $800. © Cambridge Business Publishers, 2018

25 Cost-Volume-Profit Graph
$12,000 - $10,000 - $8,000 - $6,000 - $4,000 - $2,000 - $0 - , , , ,000 Unit Sales Variable costs line $1.10 per unit Fixed costs $1,780 Loss area Profit area Total Revenues and Total Costs Total revenue line $1.50 per unit Break-even point 4,450 units Total costs line $1,780 + $1.10 per unit © Cambridge Business Publishers, 2018

26 Total profit or loss line
Profit-Volume Graph Total Revenues Break-even point $6,675 Profit area Loss area $900 - $600 - $300 - $0 - ($300) - ($600) - ($900) - $4, $8, $12,000 Total Profit or (Loss) Total profit or loss line © Cambridge Business Publishers, 2018

27 Impact of Income Taxes Determining the unit sales volume required to earn a desired after-tax profit: After-tax profit (1 – Tax rate) = Before-tax profit Determine the required before-tax profit. Step 1: Substitute the required before-tax profit into the profit formula. Step 2: Solve for the required unit sales volume. Step 3: © Cambridge Business Publishers, 2018

28 Impact of Income Taxes Example
Chillin’ Time sells ice cream bars with a $1.10 unit variable cost for $1.50 each. It is subject to a 30 percent income tax rate. How many ice cream bars must Chillin’ Time sell to earn a desired monthly after-tax profit of $840? After-tax profit (1 – Tax rate) = Before-tax profit $840 (1 – 0.30) = $1,200 $1,780 + $1,200 $ $1.10 = Target unit sales volume = 7,450 ice cream bars © Cambridge Business Publishers, 2018

29 Contribution Income Statement with Income Taxes
Sales (7,450 x $1.50) $11,175 Less variable costs: Direct materials (7,450 x $0.43) $3,204 Direct labor (7,450 x $0.32) 2,384 Variable manufacturing overhead (7,450 x $0.20) 1,490 Variable selling and administrative (7,450 x $0.15) 1,118 8,195 Contribution margin 2,980 Less fixed costs: Fixed manufacturing overhead 1,200 Fixed selling and administrative 580 1,780 Before-tax profit Income taxes ($1,200 × 30%) 360 After-tax profit $ 840 100% 30% 70% © Cambridge Business Publishers, 2018

30 Analyze the profitability and sales mix of a multiple-product firm.
4 Analyze the profitability and sales mix of a multiple-product firm. © Cambridge Business Publishers, 2018

31 Multiple Product Break-Even Point
Applicable when unit information is not available or when a company sells more than one product. Fixed costs Contribution margin ratio = Dollar break-even point Fixed costs + Desired profit Contribution margin ratio = Target dollar sales volume © Cambridge Business Publishers, 2018

32 Sales Mix Analysis Sales mix
The relative portion of unit or dollar sales that are derived from each product When sales mix is constant, the basic cost- volume-profit model can be used effectively When sales mix is not constant, must determine average unit contribution margin or average contribution margin ratio for each alternative mix © Cambridge Business Publishers, 2018

33 Unit Sales Analysis It is now 2018 and Chillin’ Time has two products – ice cream bars and popsicles, with the following information: Ice Cream Bars Popsicles Total Unit sales 5,000 10,000 Selling price per unit $2.00 $0.80 Variable cost per unit $1.10 $0.40 Fixed costs per month $ 3,400 Sales revenue $10,000 $4,000 $14,000 Variable costs 5,500 2,000 7,500 Contribution margin $ 4,500 $2,000 $ 6,500 Contribution margin ratio 0.450 0.500 Current sales mix based on units: 5,000 to 5,000 or 1 to 1. Chillin’ Time sells 1 ice cream bar for every popsicle sold. © Cambridge Business Publishers, 2018

34 Unit Multi-Product Break-Even Example
Average contribution margin per unit = [($0.90 x 1) + ($0.40 x 1)] / 2 units = $0.65 Fixed costs Unit contribution margin = Unit break-even point $3,400 $0.65 = = 5, ≈ 5,231 units Ice cream bars: 5,231 x 1/2 = 2,616* and Popsicles: 5,231 x 1/2 = 2,616* *rounded © Cambridge Business Publishers, 2018

35 Unit Multi-Product Break-Even Example
If the sales mix changes to 4:1, how much will the unit break-even sales volume be? Average contribution margin per unit = [($0.90 x 4) + ($0.40 x 1)] / 5 units = $0.80 Unit break-even point with new sales mix: Fixed costs Unit contribution margin = $3,400 $0.80 4,250 units Ice cream bars: 4,250 x 4/5 = 3,400 and Popsicles: 4,250 x 1/5 = 850 © Cambridge Business Publishers, 2018

36 Comparing Break-Even Example
Break-even units Sales Mix 1 to 1 Ice cream bars: 5,231 x 1/2 = 2,616* and Popsicles: 5,231 x 1/2 = 2,616* *rounded Sales Mix 4 to 1 Ice cream bars: 4,250 x 4/5 = 3,400 and Popsicles: 4,250 x 1/5 = 850 The change in sales mix causes the total number of units needed to break even to change because of the different contribution margins for the two products. © Cambridge Business Publishers, 2018

37 Dollar Multi-Product Break-Even Example
Current sales mix in dollars is $10,000 to $4,000 or about 71% to 29%. How much is the break-even sales volume in dollars? Average contribution margin ratio = $6,500 / $14,000 = 0.464 Dollar break-even point with new sales mix: Fixed costs Contribution margin per unit = $3,400 0.464 = $7,328 Ice cream bars: $7,328 x 0.71 = $5,203 and Popsicles: $7,328 x 0.29 = $2,125 © Cambridge Business Publishers, 2018

38 Dollar Multi-Product Break-Even Example
Current sales mix in dollars is $10,000 to $4,000 or about 71% to 29%. If the sales mix changes to a 60% to 40% ratio, how much will the break-even sales volume in dollars be? Average contribution margin ratio = [(0.45 x 0.60) + (0.50 x 0.40)] = 0.47 Dollar break-even point with new sales mix: Fixed costs Contribution margin per unit = $3,400 0.47 = $7,234 Ice cream bars: $7,234 x 0.60 = $4,340 and Popsicles: $7,234 x 0.40 = $2,894 © Cambridge Business Publishers, 2015

39 Comparing Break-Even Example
Break-even sales dollars Sales Mix 71% to 29% Ice cream bars: $7,328 x 0.71 = $5,203 and Popsicles: $7,328 x 0.29 = $2,125 Sales Mix 60% to 40% Ice cream bars: $7,234 x 0.60 = $4,340 and Popsicles: $7,234 x 0.40 = $2,894 The change in sales mix causes the sales dollars needed to break even to change because of the different contribution margins for the two products. © Cambridge Business Publishers, 2018

40 5 Apply operating leverage ratio to assess opportunities for profit and the risks of loss. © Cambridge Business Publishers, 2018

41 Degree of operating leverage
What is operating leverage? A measure of the extent that an organization’s costs are fixed Contribution margin Income before taxes = Degree of operating leverage High degree of operating leverage Signals the existence of a high portion of fixed costs © Cambridge Business Publishers, 2018

42 Operating Leverage Risk and Opportunity
Sales Increase Sales Decrease High operating leverage High opportunity for profit increases High risk of loss Low operating leverage Low opportunity for profit increases Low risk The higher the degree of operating leverage… The greater the opportunity for profit with increases in sales, AND The greater the risk of large losses when sales decrease © Cambridge Business Publishers, 2018

43 Measuring Expected Change in Profit
Taco Express and Mia’s Cantina are competitors and reported the same sales revenue and before-tax profit during May: Taco Express Mia’s Cantina Sales $40,000 $40,000. Variable costs (22,000) (8,000) Contribution margin 18,000 32,000. Fixed costs Before-tax profit $10,000 $10,000. Taco Express Mia’s Cantina Degree of operating leverage $18,000 = 1.8 $32,000 = 3.2 $10,000 If sales drop by 20% for both, which company suffers more? Decrease in profit 1.8 x 20% = 36% 3.2 x 20% = 64% Decline in Profit Mia’s Cantina's higher operating leverage results in a larger profit decline. © Cambridge Business Publishers, 2018

44 Perform profitability analysis with unit and nonunit cost drivers.
6 Appendix 16A Perform profitability analysis with unit and nonunit cost drivers. © Cambridge Business Publishers, 2018

45 Profitability Analysis Considerations
Limitation Only one activity cost driver used Unit-level approach based on the assumption that units sold or sales dollars is the only cost driver Solution Use a cost hierarchy approach that incorporates non-unit as well as unit-level activity cost drivers © Cambridge Business Publishers, 2018

46 Multi-Level Contribution Income Statement with Income Taxes
Sales $ 3,000,000. Less unit-level costs: Cost of goods sold ($3,000,000 x 0.80) (2,400,000) Unit level contribution margin 600,000. Cost of processing order (3,200 orders x $20) (64,000) Order-level contribution margin 536,000. Less customer-level costs: Mail, phone, sales visits, recordkeeping, etc. (400 customers x $200) (80,000) Customer-level contribution margin 456,000. Less facility-level costs: Depreciation, manager salaries, insurance, etc (120,000) Before-tax profit 336,000. Income taxes ($336,000 x 0.40) ,400. After-tax profit $ ,600. © Cambridge Business Publishers, 2018

47 Unit-Level Break-Even Example
The following costs have been determined based on the multi-level break-even contribution income statement: Type of Activity Cost Unit-level $0.80 per sales dollar Order-level $64,000 Customer-level $80,000 Facility-level $120,000 Assuming no changes in other costs, what is the unit-level break-even dollar sales volume? Order- level costs Customer-level costs Facility-level costs + Contribution margin ratio [$64,000 + $80,000 + $120,000] ÷ [1 ‒ 0.8] = $1,320,000 © Cambridge Business Publishers, 2018

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