1. Copyright © 2007 Prentice-Hall. All rights reserved 1 Cost-Volume-Profit Analysis Chapter 7

2. Copyright © 2007 Prentice-Hall. All rights reserved 2 Objective 1 Calculate the unit contribution margin and the contribution margin ratio

3. Copyright © 2007 Prentice-Hall. All rights reserved 3 Components of CVP Analysis Sales price per unit Volume sold Variable costs per unit Fixed costs Operating income

4. Copyright © 2007 Prentice-Hall. All rights reserved 4 CVP Assumptions 1.Change in volume is only factor that affects costs 2.Can classify each cost as either variable or fixed. (These costs are linear throughout relevant range) 3.Revenues are linear throughout relevant range 4.Inventory levels will not change 5.The sales mix of products will not change

5. Copyright © 2007 Prentice-Hall. All rights reserved 5 Unit Contribution Margin Sales price per unit - Variable costs per unit Contribution margin per unit

6. Copyright © 2007 Prentice-Hall. All rights reserved 6 Contribution Margin Ratio Unit contribution margin Sales price per unit

7. Copyright © 2007 Prentice-Hall. All rights reserved 7 Objective 2 Use CVP analysis to find breakeven points and target profit volumes

8. Copyright © 2007 Prentice-Hall. All rights reserved 8 Breakeven Point Sales level at which operating income is zero Sales above breakeven result in a profit Sales below breakeven result in a loss

9. Copyright © 2007 Prentice-Hall. All rights reserved 9 Income Statement Approach Contribution Margin Income Statement Sales - Variable Costs Contribution Margin - Fixed Costs Operating Income

10. Copyright © 2007 Prentice-Hall. All rights reserved 10 Short-Cut Approach Using the Unit Contribution Margin Fixed expenses + Operating income Contribution margin per unit Units sold =

11. Copyright © 2007 Prentice-Hall. All rights reserved 11 Short-Cut Approach Using the Unit Contribution Margin Ratio Fixed expenses + Operating income Contribution margin ratio Sales in $ =

12. Copyright © 2007 Prentice-Hall. All rights reserved 12 E7-15 1. Contribution margin ratio = Contribution margin ÷ Sales = $187,500 ÷ $312,500 = 60%

13. Copyright © 2007 Prentice-Hall. All rights reserved 13 E7-15 1. Aussie Travel Contribution Margin Income Statements Sales revenue$250,000$360,000 Variable expenses (40%) 100,000144,000 Contribution margin$150,000$216,000 Fixed expenses 170,00170,000 Operating income (loss)$ (20,000)$46,000

14. Copyright © 2007 Prentice-Hall. All rights reserved 14 E7-15 2. Fixed expenses + Operating income Contribution margin ratio Sales in $ = $170,000 + $0 60% Sales in $ = = $283,333

15. Copyright © 2007 Prentice-Hall. All rights reserved 15 E7-16 1 Contribution margin = Sales–Variable costs = $1.70 - $0.85 = $0.85 Contribution margin ratio: Contribution margin per unit $0.85 Sales price per unit$1.70 ==50%

16. Copyright © 2007 Prentice-Hall. All rights reserved 16 E7-16 2 Breakeven sales in units: Fixed costs + Operating income Contribution margin per unit ($85,000 + $0) / $0.85 = 100,000 units

17. Copyright © 2007 Prentice-Hall. All rights reserved 17 E7-16 2 Breakeven sales in dollars: Fixed costs + Operating income Contribution margin ratio ($85,000 + $0) / 50% = $170,000

18. Copyright © 2007 Prentice-Hall. All rights reserved 18 E7-16 3 Sales in units: Fixed costs + Operating income Contribution margin per unit ($85,000 + $25,000) / $0.85 = 129,412 units

19. Copyright © 2007 Prentice-Hall. All rights reserved 19 Preparing a CVP Chart Step 1: –Choose a sales volume. –Plot point for total sales revenue. –Draw sales revenue line from origin.

20. Copyright © 2007 Prentice-Hall. All rights reserved 20 Preparing a CVP Chart

21. Copyright © 2007 Prentice-Hall. All rights reserved 21 Preparing a CVP Chart Step 2: –Draw the fixed cost line

22. Copyright © 2007 Prentice-Hall. All rights reserved 22 Preparing a CVP Chart

23. Copyright © 2007 Prentice-Hall. All rights reserved 23 Preparing a CVP Chart Step 3: –Draw the total cost line ( fixed plus variable)

24. Copyright © 2007 Prentice-Hall. All rights reserved 24 Preparing a CVP Chart

25. Copyright © 2007 Prentice-Hall. All rights reserved 25 Preparing a CVP Chart Step 4: –Identify the breakeven point and the areas of operating income and loss

26. Copyright © 2007 Prentice-Hall. All rights reserved 26 Preparing a CVP Chart Breakeven point

27. Copyright © 2007 Prentice-Hall. All rights reserved 27 Preparing a CVP Chart Step 5: –Mark operating income and operating loss areas on graph

28. Copyright © 2007 Prentice-Hall. All rights reserved 28 Preparing a CVP Chart Breakeven point Operating income Operating Loss

29. Copyright © 2007 Prentice-Hall. All rights reserved 29 E7-20 Revenues

30. Copyright © 2007 Prentice-Hall. All rights reserved 30 E7-20 Fixed Costs Revenues

31. Copyright © 2007 Prentice-Hall. All rights reserved 31 E7-20 Breakeven point Total Costs Fixed Costs Revenues

32. Copyright © 2007 Prentice-Hall. All rights reserved 32 Operating Loss Operating income E7-20 Total Costs Revenues

33. Copyright © 2007 Prentice-Hall. All rights reserved 33 E7-20 ($24 x units sold)-($4 x units sold)-$24,000,000 = $0 ($20 x units sold) = $0 + $24,000,000 Units sold = $24,000,000 ÷ $20 = 1,200,000 tickets 1,200,000 x $24 per ticket = $28,800,000

34. Copyright © 2007 Prentice-Hall. All rights reserved 34 Objective 3 Perform sensitivity analysis in response to changing business conditions

35. Copyright © 2007 Prentice-Hall. All rights reserved 35 Sensitivity Analysis “What if” analysis What if the sales price changes? What if costs change?

36. Copyright © 2007 Prentice-Hall. All rights reserved 36 E7-22 Sales needed to Breakeven = Fixed Costs ÷ Contribution Margin Ratio $500,000 = Fixed Costs ÷.40 $500,000 ×.40= Fixed Costs $200,000 = Fixed Costs New fixed costs = $240,000

37. Copyright © 2007 Prentice-Hall. All rights reserved 37 E7-22 Sales needed to Breakeven = Fixed Costs ÷ Contribution Margin Ratio $240,000 ÷.40 = $600,000

38. Copyright © 2007 Prentice-Hall. All rights reserved 38 E7-23 Sale price per scarf$16 Contribution margin ratio x.625 Contribution margin per unit$10 Scarves needed to pay for extra entrance fee cost of $150 ($1,000 x 15%): $150 ÷ $10 = 15 scarves

39. Copyright © 2007 Prentice-Hall. All rights reserved 39 Objective 4 Find breakeven and target profit volumes for multiproduct companies

40. Copyright © 2007 Prentice-Hall. All rights reserved 40 Multiple Product Break-Even Point – E7-27 Step 1: Calculate weighted-average contribution margin StandardChromeTotal Sale price per unit$54$78 Variable costs per unit3650 Contribution margin per unit$18$28 Sales mix in unitsx 3x 2 Contribution margin$54$56$110 Weighted average contribution Margin per unit ($110 / 5)$22

41. Copyright © 2007 Prentice-Hall. All rights reserved 41 Multiple Product Break-Even Point – E7-27 Step 2: Calculate the breakeven point in units Fixed costs + Operating income Weighted average contribution margin per unit ($9,680 + $0) ÷ $22 = 440 composite units

42. Copyright © 2007 Prentice-Hall. All rights reserved 42 Multiple Product Break-Even Point – E7-27 Step 3: Calculate the breakeven point in units for each product line Standard: 440 units x 3/5 = 264 units Chrome: 440 units x 2/5 = 176 units

43. Copyright © 2007 Prentice-Hall. All rights reserved 43 E7-27 To earn $6,600 Fixed costs + Operating income Weighted average contribution margin per unit ($9,680 + $6,600) ÷ $22 = 740 composite units Standard: 740 x 3/5 = 444 Chrome: 740 x 2/5 = 296

44. Copyright © 2007 Prentice-Hall. All rights reserved 44 Objective 5 Determine a firm’s margin of safety and operating leverage

45. Copyright © 2007 Prentice-Hall. All rights reserved 45 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

46. Copyright © 2007 Prentice-Hall. All rights reserved 46 Margin of Safety In units: Expected sales in units – Breakeven sales in units In dollars: Margin of safety in units x Sale price per unit

47. Copyright © 2007 Prentice-Hall. All rights reserved 47 Margin of Safety As a Percentage Margin of safety in units ÷ Expected sales in units In dollars: Margin of safety in $ ÷ Expected sales in $

48. Copyright © 2007 Prentice-Hall. All rights reserved 48 E7-32 1. Margin of safety = Expected sales – breakeven sales Expected sales: Sales – variable costs – fixed costs = operating income Sales – 70% Sales - $9,000 = $12,000 30% Sales = $9,000 + $12,000 Sales = $70,000

49. Copyright © 2007 Prentice-Hall. All rights reserved 49 E7-32 1. Margin of safety = Expected sales – breakeven sales Breakeven sales: Sales – variable costs – fixed costs = operating income Sales - 70% x Sales - $9,000 = $0 30% Sales = $9,000 Sales = $30,000

50. Copyright © 2007 Prentice-Hall. All rights reserved 50 E7-32 1. Margin of safety = Expected sales – breakeven sales = $70,000 - $30,000 = $40,000

51. Copyright © 2007 Prentice-Hall. All rights reserved 51 E7-32 2. Margin of safety as a % of target sales = $40,000 ÷ $70,000 = 57%

52. Copyright © 2007 Prentice-Hall. All rights reserved 52 Operating Leverage Relative amount of fixed and variable costs that make up total costs Operating leverage factor: Contribution margin Operating income Indicates percentage change in operating income that will occur from a 1% change in volume

53. Copyright © 2007 Prentice-Hall. All rights reserved 53 Operating Leverage High operating leverage –relatively more fixed costs –relatively high contribution margin ratio Higher risk if volume decreases Higher potential for reward if volume increases

54. Copyright © 2007 Prentice-Hall. All rights reserved 54 Operating Leverage Low operating leverage –relatively more variable costs –relatively small contribution margin ratio Lower risk if volume decreases Lower potential for reward if volume increases

55. Copyright © 2007 Prentice-Hall. All rights reserved 55 Operating Leverage Factor Contribution margin Operating income

56. Copyright © 2007 Prentice-Hall. All rights reserved 56 E7-32 3. Sales $70,000 Variable costs (70%)49,000 Contribution margin$21,000 Operating leverage: Contribution margin ÷ Operating income $21,000 ÷ $12,000 = 1.75

57. Copyright © 2007 Prentice-Hall. All rights reserved 57 E7-32 4. If volume decreases 10%, income will decrease: 10% x 1.75 = 17.5%

58. Copyright © 2007 Prentice-Hall. All rights reserved 58 End of Chapter 7