1. McGraw-Hill/Irwin1 © The McGraw-Hill Companies, Inc., 2006 22-1 Cost-Volume- Profit Analysis Chapter 22

2. McGraw-Hill/Irwin2 © The McGraw-Hill Companies, Inc., 2006 22-2 CVP analysis is used to answer questions such as: How much must I sell to earn my desired income? How will income be affected if I reduce selling prices to increase sales volume? How will income be affected if I change the sales mix of my products? CVP analysis is used to answer questions such as: How much must I sell to earn my desired income? How will income be affected if I reduce selling prices to increase sales volume? How will income be affected if I change the sales mix of my products? Questions Addressed by Cost-Volume-Profit Analysis

3. McGraw-Hill/Irwin3 © The McGraw-Hill Companies, Inc., 2006 22-3 Number of Local Calls Monthly Basic Telephone Bill Total fixed costs remain unchanged when activity changes. Your monthly basic telephone bill probably does not change when you make more local calls. Total Fixed Cost

4. McGraw-Hill/Irwin4 © The McGraw-Hill Companies, Inc., 2006 22-4 Number of Local Calls Monthly Basic Telephone Bill per Local Call Fixed costs per unit decline as activity increases. Your average cost per local call decreases as more local calls are made. Fixed Cost Per Unit

5. McGraw-Hill/Irwin5 © The McGraw-Hill Companies, Inc., 2006 22-5 Minutes Talked Total Long Distance Telephone Bill Total variable costs change when activity changes. Your total long distance telephone bill is based on how many minutes you talk. Total Variable Cost

6. McGraw-Hill/Irwin6 © The McGraw-Hill Companies, Inc., 2006 22-6 Minutes Talked Per Minute Telephone Charge Variable costs per unit do not change as activity increases. The cost per long distance minute talked is constant. For example, 7 cents per minute. Variable Cost Per Unit

7. McGraw-Hill/Irwin7 © The McGraw-Hill Companies, Inc., 2006 22-7 Cost Behavior Summary

8. McGraw-Hill/Irwin8 © The McGraw-Hill Companies, Inc., 2006 22-8 Mixed costs contain a fixed portion that is incurred even when facility is unused, and a variable portion that increases with usage. Example: monthly electric utility charge Fixed service fee Variable charge per kilowatt hour used Mixed Costs

9. McGraw-Hill/Irwin9 © The McGraw-Hill Companies, Inc., 2006 22-9 Variable Utility Charge Activity (Kilowatt Hours) Total Utility Cost Total mixed cost Fixed Monthly Utility Charge Mixed Costs

10. McGraw-Hill/Irwin10 © The McGraw-Hill Companies, Inc., 2006 22-10 Activity Cost Total cost remains constant within a narrow range of activity. Step-Wise Costs

11. McGraw-Hill/Irwin11 © The McGraw-Hill Companies, Inc., 2006 22-11 Activity Cost Total cost increases to a new higher cost for the next higher range of activity. Step-Wise Costs

12. McGraw-Hill/Irwin12 © The McGraw-Hill Companies, Inc., 2006 22-12 Costs that increase when activity increases, but in a nonlinear manner. Activity Total Cost Curvilinear Costs

13. McGraw-Hill/Irwin13 © The McGraw-Hill Companies, Inc., 2006 22-13 The objective is to classify all costs as either fixed or variable. Identifying and Measuring Cost Behavior

14. McGraw-Hill/Irwin14 © The McGraw-Hill Companies, Inc., 2006 22-14 A scatter diagram of past cost behavior may be helpful in analyzing mixed costs. Scatter Diagram

15. McGraw-Hill/Irwin15 © The McGraw-Hill Companies, Inc., 2006 22-15 Plot the data points on a graph (total cost vs. activity). 0 1 2 3 4 * Total Cost in 1,000’s of Dollars 10 20 0 * * * * * * * * * Activity, 1,000’s of Units Produced Scatter Diagram

16. McGraw-Hill/Irwin16 © The McGraw-Hill Companies, Inc., 2006 22-16 Draw a line through the plotted data points so that about equal numbers of points fall above and below the line. Estimated fixed cost = 10,000 0 1 2 3 4 * Total Cost in 1,000’s of Dollars 10 20 0 * * * * * * * * * Activity, 1,000’s of Units Produced Scatter Diagram

17. McGraw-Hill/Irwin17 © The McGraw-Hill Companies, Inc., 2006 22-17 Vertical distance is the change in cost. Horizontal distance is the change in activity. Unit Variable Cost = Slope =  in cost  in units 0 1 2 3 4 * Total Cost in 1,000’s of Dollars 10 20 0 * * * * * * * * * Activity, 1,000’s of Units Produced Scatter Diagram

18. McGraw-Hill/Irwin18 © The McGraw-Hill Companies, Inc., 2006 22-18 The following relationships between sales and costs are observed: Using these two levels of activity, compute:  the variable cost per unit.  the total fixed cost. The High-Low Method Exh. 22-6

19. McGraw-Hill/Irwin19 © The McGraw-Hill Companies, Inc., 2006 22-19  Unit variable cost = = = $0.17 per $  in cost  in units $8,500 $50,000 The High-Low Method Exh. 22-6

20. McGraw-Hill/Irwin20 © The McGraw-Hill Companies, Inc., 2006 22-20  Unit variable cost = = = $0.17 per $  Fixed cost = Total cost – Total variable  in cost  in units $8,500 $50,000 The High-Low Method Exh. 22-6

21. McGraw-Hill/Irwin21 © The McGraw-Hill Companies, Inc., 2006 22-21  Unit variable cost = = = $0.17 per $  Fixed cost = Total cost – Total variable cost Fixed cost = $29,000 – ($0.17 per sales $ × $67,500) Fixed cost = $29,000 – $11,475 = $17,525  in cost  in units $8,500 $50,000 The High-Low Method Exh. 22-6

22. McGraw-Hill/Irwin22 © The McGraw-Hill Companies, Inc., 2006 22-22 The objective of the cost analysis remains the same: determination of total fixed cost and the variable unit cost. Least-squares regression is usually covered in advanced cost accounting courses. It is commonly used with computer software because of the large number of calculations required. Least-Squares Regression

23. McGraw-Hill/Irwin23 © The McGraw-Hill Companies, Inc., 2006 22-23 Let’s extend our knowledge of cost behavior to break-even analysis. Break-Even Analysis

24. McGraw-Hill/Irwin24 © The McGraw-Hill Companies, Inc., 2006 22-24 The break-even point (expressed in units of product or dollars of sales) is the unique sales level at which a company earns neither a profit nor incurs a loss. Computing Break-Even Point

25. McGraw-Hill/Irwin25 © The McGraw-Hill Companies, Inc., 2006 22-25 Contribution margin is amount by which revenue exceeds the variable costs of producing the revenue. Computing Break-Even Point

26. McGraw-Hill/Irwin26 © The McGraw-Hill Companies, Inc., 2006 22-26 How much contribution margin must this company have to cover its fixed costs (break even)? Answer: $30,000 Computing Break-Even Point

27. McGraw-Hill/Irwin27 © The McGraw-Hill Companies, Inc., 2006 22-27 How many units must this company sell to cover its fixed costs (break even)? Answer: $30,000 ÷ $20 per unit = 1,500 units Computing Break-Even Point

28. McGraw-Hill/Irwin28 © The McGraw-Hill Companies, Inc., 2006 22-28 We have just seen one of the basic CVP relationships – the break-even computation. Break-even point in units = Fixed costs Contribution margin per unit Computing Break-Even Point Unit sales price less unit variable cost ($20 in previous example) Exh. 22-8

29. McGraw-Hill/Irwin29 © The McGraw-Hill Companies, Inc., 2006 22-29 The break-even formula may also be expressed in sales dollars. Break-even point in dollars = Fixed costs Contribution margin ratio Unit contribution margin Unit sales price Computing Break-Even Point Exh. 22-9

30. McGraw-Hill/Irwin30 © The McGraw-Hill Companies, Inc., 2006 22-30 ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to break even? a. 100,000 units b. 40,000 units c. 200,000 units d. 66,667 units ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to break even? a. 100,000 units b. 40,000 units c. 200,000 units d. 66,667 units Computing Break-Even Point

31. McGraw-Hill/Irwin31 © The McGraw-Hill Companies, Inc., 2006 22-31 ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to break even? a. 100,000 units b. 40,000 units c. 200,000 units d. 66,667 units ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to break even? a. 100,000 units b. 40,000 units c. 200,000 units d. 66,667 units Unit contribution = $5.00 - $3.00 = $2.00 Fixed costs Unit contribution = $200,000 $2.00 per unit = 100,000 units Computing Break-Even Point

32. McGraw-Hill/Irwin32 © The McGraw-Hill Companies, Inc., 2006 22-32 Use the contribution margin ratio formula to determine the amount of sales revenue ABC must have to break even. All information remains unchanged: fixed costs are $200,000; unit sales price is $5.00; and unit variable cost is $3.00. a. $200,000 b. $300,000 c. $400,000 d. $500,000 Use the contribution margin ratio formula to determine the amount of sales revenue ABC must have to break even. All information remains unchanged: fixed costs are $200,000; unit sales price is $5.00; and unit variable cost is $3.00. a. $200,000 b. $300,000 c. $400,000 d. $500,000 Computing Break-Even Point

33. McGraw-Hill/Irwin33 © The McGraw-Hill Companies, Inc., 2006 22-33 Use the contribution margin ratio formula to determine the amount of sales revenue ABC must have to break even. All information remains unchanged: fixed costs are $200,000; unit sales price is $5.00; and unit variable cost is $3.00. a. $200,000 b. $300,000 c. $400,000 d. $500,000 Use the contribution margin ratio formula to determine the amount of sales revenue ABC must have to break even. All information remains unchanged: fixed costs are $200,000; unit sales price is $5.00; and unit variable cost is $3.00. a. $200,000 b. $300,000 c. $400,000 d. $500,000 Unit contribution = $5.00 - $3.00 = $2.00 Contribution margin ratio = $2.00 ÷ $5.00 =.40 Break-even revenue = $200,000 ÷.4 = $500,000 Computing Break-Even Point

34. McGraw-Hill/Irwin34 © The McGraw-Hill Companies, Inc., 2006 22-34 Volume in Units Costs and Revenue in Dollars Total fixed costs Total costs  Draw the total cost line with a slope equal to the unit variable cost.  Plot total fixed costs on the vertical axis. Preparing a CVP Chart

35. McGraw-Hill/Irwin35 © The McGraw-Hill Companies, Inc., 2006 22-35 Sales Volume in Units Costs and Revenue in Dollars  Starting at the origin, draw the sales line with a slope equal to the unit sales price. Preparing a CVP Chart Break- even Point Total costs Total fixed costs

36. McGraw-Hill/Irwin36 © The McGraw-Hill Companies, Inc., 2006 22-36  A limited range of activity called the relevant range, where CVP relationships are linear. 4 Unit selling price remains constant. 4 Unit variable costs remain constant. 4 Total fixed costs remain constant.  Production = sales (no inventory changes). Assumptions of CVP Analysis

37. McGraw-Hill/Irwin37 © The McGraw-Hill Companies, Inc., 2006 22-37 Income (pretax) = Sales – Variable costs – Fixed costs Computing Income from Expected Sales Exh. 22-12

38. McGraw-Hill/Irwin38 © The McGraw-Hill Companies, Inc., 2006 22-38 Rydell expects to sell 1,500 units at $100 each next month. Fixed costs are $24,000 per month and the unit variable cost is $70. What amount of income should Rydell expect? Income (pretax) = Sales – Variable costs – Fixed costs = [ 1,500 units × $100 ] – [ 1,500 units × $70 ] – $24,000 = $21,000 Income (pretax) = Sales – Variable costs – Fixed costs = [ 1,500 units × $100 ] – [ 1,500 units × $70 ] – $24,000 = $21,000 Computing Income from Expected Sales Exh. 22-13

39. McGraw-Hill/Irwin39 © The McGraw-Hill Companies, Inc., 2006 22-39 Break-even formulas may be adjusted to show the sales volume needed to earn any amount of income. Unit sales = Fixed costs + Target income Contribution margin per unit Dollar sales = Fixed costs + Target income Contribution margin ratio Computing Sales for a Target Income

40. McGraw-Hill/Irwin40 © The McGraw-Hill Companies, Inc., 2006 22-40 ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to earn income of $40,000? a. 100,000 units b. 120,000 units c. 80,000 units d. 200,000 units ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to earn income of $40,000? a. 100,000 units b. 120,000 units c. 80,000 units d. 200,000 units Computing Sales for a Target Income

41. McGraw-Hill/Irwin41 © The McGraw-Hill Companies, Inc., 2006 22-41 ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to earn income of $40,000? a. 100,000 units b. 120,000 units c. 80,000 units d. 200,000 units ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to earn income of $40,000? a. 100,000 units b. 120,000 units c. 80,000 units d. 200,000 units = 120,000 units Unit contribution = $5.00 - $3.00 = $2.00 Fixed costs + Target income Unit contribution $200,000 + $40,000 $2.00 per unit Computing Sales for a Target Income

42. McGraw-Hill/Irwin42 © The McGraw-Hill Companies, Inc., 2006 22-42 Target net income is income after income tax. Dollar sales = Fixed Target net Income costs income taxes Contribution margin ratio ++ Computing Sales (Dollars) for a Target Net Income Exh. 22-14

43. McGraw-Hill/Irwin43 © The McGraw-Hill Companies, Inc., 2006 22-43 To convert target net income to before-tax income, use the following formula: Before-tax income = Target net income 1 - tax rate Computing Sales (Dollars) for a Target Net Income

44. McGraw-Hill/Irwin44 © The McGraw-Hill Companies, Inc., 2006 22-44 Rydell has a monthly target net income of $18,000. The unit selling price is $100. Monthly fixed costs are $24,000, the unit variable cost is $70, and the tax rate is 25 percent.  What is Rydell’s before-tax income and income tax expense? Computing Sales (Dollars) for a Target Net Income

45. McGraw-Hill/Irwin45 © The McGraw-Hill Companies, Inc., 2006 22-45 Before-tax income = Target net income 1 - tax rate Before-tax income = = $24,000 $18,000 1 -.25 Income tax =.25 × $24,000 = $6,000 Rydell has a monthly target net income of $18,000. The unit selling price is $100. Monthly fixed costs are $24,000, the unit variable cost is $70, and the tax rate is 25 percent.  What is Rydell’s before-tax income and income tax expense? Computing Sales (Dollars) for a Target Net Income

46. McGraw-Hill/Irwin46 © The McGraw-Hill Companies, Inc., 2006 22-46 Rydell has a monthly target net income of $18,000. The unit selling price is $100. Monthly fixed costs are $24,000, the unit variable cost is $70, and the tax rate is 25 percent.  What monthly sales revenue will Rydell need to earn the target net income? Computing Sales (Dollars) for a Target Net Income

47. McGraw-Hill/Irwin47 © The McGraw-Hill Companies, Inc., 2006 22-47 Dollar sales = Fixed Target net Income costs income taxes Contribution margin ratio ++ Dollar sales = = $160,000 $24,000 + $18,000 + $6,000 30% Rydell has a monthly target net income of $18,000. The unit selling price is $100. Monthly fixed costs are $24,000, the unit variable cost is $70, and the tax rate is 25 percent.  What monthly sales revenue will Rydell need to earn the target net income? Computing Sales (Dollars) for a Target Net Income

48. McGraw-Hill/Irwin48 © The McGraw-Hill Companies, Inc., 2006 22-48 The formula for computing dollar sales may be used to compute unit sales by substituting contribution per unit in the denominator. Contribution margin per unit Unit sales = Fixed Target net Income costs income taxes ++ Unit sales = = 1,600 units $24,000 + $18,000 + $6,000 $30 per unit Formula for Computing Sales (Units) for a Target Net Income Exh. 22-16

49. McGraw-Hill/Irwin49 © The McGraw-Hill Companies, Inc., 2006 22-49 Margin of safety is the amount by which sales may decline before reaching break- even sales. Margin of safety may be expressed as a percentage of expected sales. Computing the Margin of Safety Exh. 22-17 Margin of safety Expected sales - Break-even sales percentage Expected sales =

50. McGraw-Hill/Irwin50 © The McGraw-Hill Companies, Inc., 2006 22-50 Margin of safety Expected sales - Break-even sales percentage Expected sales = If Rydell’s sales are $100,000 and break- even sales are $80,000, what is the margin of safety in dollars and as a percentage? Computing the Margin of Safety Exh. 22-17

51. McGraw-Hill/Irwin51 © The McGraw-Hill Companies, Inc., 2006 22-51 If Rydell’s sales are $100,000 and break- even sales are $80,000, what is the margin of safety in dollars and as a percentage? Margin of safety = $100,000 - $80,000 = $20,000 Margin of safety Expected sales - Break-even sales percentage Expected sales = Margin of safety $100,000 - $80,000 percentage $100,000 = = 20% Computing the Margin of Safety Exh. 22-17

52. McGraw-Hill/Irwin52 © The McGraw-Hill Companies, Inc., 2006 22-52 The basic CVP relationships may be used to analyze a number of situations such as changing sales price, changing variable cost, or changing fixed cost. Consider the following example. The basic CVP relationships may be used to analyze a number of situations such as changing sales price, changing variable cost, or changing fixed cost. Consider the following example. Continue Sensitivity Analysis

53. McGraw-Hill/Irwin53 © The McGraw-Hill Companies, Inc., 2006 22-53 Rydell Company is considering buying a new machine that would increase monthly fixed costs from $24,000 to $30,000, but decrease unit variable costs from $70 to $60. The $100 per unit selling price would remain unchanged. What is the new break-even point in dollars? Sensitivity Analysis Example

54. McGraw-Hill/Irwin54 © The McGraw-Hill Companies, Inc., 2006 22-54 Rydell Company is considering buying a new machine that would increase monthly fixed costs from $24,000 to $30,000, but decrease unit variable costs from $70 to $60. The $100 per unit selling price would remain unchanged. Revised Break-even point in dollars Revised fixed costs Revised contribution margin ratio Revised Break-even point in dollars $30,000 40% = $75,000= = Sensitivity Analysis Example Exh. 22-18

55. McGraw-Hill/Irwin55 © The McGraw-Hill Companies, Inc., 2006 22-55 The CVP formulas may be modified for use when a company sells more than one product. The unit contribution margin is replaced with the contribution margin for a composite unit. A composite unit is composed of specific numbers of each product in proportion to the product sales mix. Sales mix is the ratio of the volumes of the various products. Computing Multiproduct Break-Even Point

56. McGraw-Hill/Irwin56 © The McGraw-Hill Companies, Inc., 2006 22-56 The resulting break-even formula for composite unit sales is: Break-even point in composite units Fixed costs Contribution margin per composite unit = Consider the following example: Continue Computing Multiproduct Break-Even Point Exh. 22-19

57. McGraw-Hill/Irwin57 © The McGraw-Hill Companies, Inc., 2006 22-57 Hair-Today offers three cuts as shown below. Annual fixed costs are $96,000. Compute the break-even point in composite units and in number of units for each haircut at the given sales mix. Computing Multiproduct Break-Even Point

58. McGraw-Hill/Irwin58 © The McGraw-Hill Companies, Inc., 2006 22-58 Hair-Today offers three cuts as shown below. Annual fixed costs are $96,000. Compute the break-even point in composite units and in number of units for each haircut at the given sales mix. A 4:2:1 sales mix means that if there are 500 budget cuts, then there will be 1,000 ultra cuts, and 2,000 basic cuts. Computing Multiproduct Break-Even Point

59. McGraw-Hill/Irwin59 © The McGraw-Hill Companies, Inc., 2006 22-59 Step 1: Compute contribution margin per composite unit. Computing Multiproduct Break-Even Point

60. McGraw-Hill/Irwin60 © The McGraw-Hill Companies, Inc., 2006 22-60 Contribution margin per composite unit Step 1: Compute contribution margin per composite unit. Computing Multiproduct Break-Even Point

61. McGraw-Hill/Irwin61 © The McGraw-Hill Companies, Inc., 2006 22-61 Break-even point in composite units Fixed costs Contribution margin per composite unit = Step 2: Compute break-even point in composite units. Computing Multiproduct Break-Even Point Exh. 22-19

62. McGraw-Hill/Irwin62 © The McGraw-Hill Companies, Inc., 2006 22-62 Break-even point in composite units Fixed costs Contribution margin per composite unit = Step 2: Compute break-even point in composite units. Break-even point in composite units $96,000 $32.00 per composite unit = Break-even point in composite units = 3,000 composite units Computing Multiproduct Break-Even Point Exh. 22-19

63. McGraw-Hill/Irwin63 © The McGraw-Hill Companies, Inc., 2006 22-63 Step 3: Determine the number of each haircut that must be sold to break even. Computing Multiproduct Break-Even Point

64. McGraw-Hill/Irwin64 © The McGraw-Hill Companies, Inc., 2006 22-64 Step 4: Verify the results. Multiproduct Break-Even Income Statement Exh. 22-20

65. McGraw-Hill/Irwin65 © The McGraw-Hill Companies, Inc., 2006 22-65 A measure of the extent to which fixed costs are being used in an organization. A measure of how a percentage change in sales will affect profits. Contribution margin Net income = Degree of operating leverage Operating Leverage

66. McGraw-Hill/Irwin66 © The McGraw-Hill Companies, Inc., 2006 22-66 $48,000 $24,000 = 2.0 Contribution margin Net income = Degree of operating leverage If Rydell increases sales by 10 percent, what will the percentage increase in income be? Operating Leverage

67. McGraw-Hill/Irwin67 © The McGraw-Hill Companies, Inc., 2006 22-67 Operating Leverage

68. McGraw-Hill/Irwin68 © The McGraw-Hill Companies, Inc., 2006 22-68 Homework for Chapter 22  Ex 22-6, 22-9, 22-11, 22-13, 22-14  Problem 22-3A, 22-5A, 22-6A

69. McGraw-Hill/Irwin69 © The McGraw-Hill Companies, Inc., 2006 22-69 End of Chapter 22