2. 6 Slide 1 Cost-Volume-Profit Analysis Chapter 6 Main Concepts: 1. Basics of CVP Analysis 2. Contribution Approach 3. Break-Even Analysis a. Equation Method b. Contribution Margin Method 4. The Concept of Sales Mix

3. 6 Slide 2 Assumptions of CVP Analysis ÊSelling price is constant throughout the entire relevant range. ËCosts are linear throughout the entire relevant range. ÌIn multi-product companies, the sales mix is constant.

4. 6 Slide 3 The Basics of Cost-Volume- Profit (CVP) Analysis Contribution Margin (CM) is the amount remaining from sales revenue after variable cost have been deducted.

5. 6 Slide 4 The Basics of Cost-Volume- Profit (CVP) Analysis CM goes to cover fixed costs.

6. 6 Slide 5 The Basics of Cost-Volume- Profit (CVP) Analysis After covering fixed costs, any remaining CM contributes to income.

7. 6 Slide 6 The Contribution Approach Consider the following information developed by the accountant at Sakuraba Co.:

8. 6 Slide 7 The Contribution Approach For each additional unit Sakuraba sells, $200 more in contribution margin will help to cover fixed costs and profit.

9. 6 Slide 8 The Contribution Approach Each month Sakuraba must generate at least $80,000 in CM to break even for the month.

10. 6 Slide 9 The Contribution Approach 400 units break-even point If Sakuraba sells 400 units in a month, it will be operating at the break-even point.

11. 6 Slide 10 The Contribution Approach If Sakuraba sells one additional unit (401 bikes), net income will increase by $200.

12. 6 Slide 11 The Contribution Approach F The break-even point can be defined either as: ÊThe point where total sales revenue equals total costs (variable and fixed). ËThe point where total contribution margin equals total fixed costs.

13. 6 Slide 12 Contribution Margin Ratio ratio F The contribution margin ratio is defined as follows: Contribution margin Contribution margin Sales Sales = CM Ratio

14. 6 Slide 13 Contribution Margin Ratio ratio F The contribution margin ratio is defined as follows: F For Sakuraba, the contribution margin ratio is: Contribution margin Contribution margin Sales Sales = CM Ratio $200 $200 $500 $500 = 40%

15. 6 Slide 14 Contribution Margin Ratio At Sakuraba, each $1.00 increase in sales revenue results in a total contribution margin increase of 40¢. If sales increase by $50,000, what will be the increase in total contribution margin? $20,000 = $.40 x $50,000

16. 6 Slide 15 Contribution Margin Ratio A $50,000 increase in sales revenue

17. 6 Slide 16 Contribution Margin Ratio A $50,000 increase in sales revenue results in a $20,000 increase in CM. ($50,000 × 40% = $20,000)

18. 6 Slide 17 Break-Even Analysis F The break-even point is the point where or ÊTotal sales revenue = total costs or ËTotal contribution margin = total fixed costs. F Break-even analysis can be approached in two ways: ÊEquation method ËContribution margin method.

19. 6 Slide 18 Equation Method Sales – (Variable costs + Fixed costs) = Profits Sales = Variable costs + Fixed costs + Profits At the break-even point profits equal zero. OR S/uX = VC/uX + Fixed costs + Profits OR

20. 6 Slide 19 Equation Method Here is the information from the Sakuraba Co.:

21. 6 Slide 20 Equation Method We calculate the break-even point as follows: S/uX = VC/uX + Fixed costs + Profits

22. 6 Slide 21 Equation Method We calculate the break-even point as follows: S/uX = VC/uX + Fixed costs + Profits $500X = $300X + $80,000 + 0 Where: X = Number of bikes sold $500 = Unit sales price $300 = Unit variable cost $80,000 = Total fixed costs

23. 6 Slide 22 Equation Method We calculate the break-even point as follows: S/uX = VC/uX + Fixed costs + Profits $500X = $300X + $80,000 + 0 $200X = $80,000

24. 6 Slide 23 Equation Method We calculate the break-even point as follows: S/uX = VC/uX + Fixed costs + Profits $500X = $300X + $80,000 + 0 $200X = $80,000 X = 400 units X = 400 units

25. 6 Slide 24 Contribution Margin Method The contribution margin method is a variation of the equation method.

26. 6 Slide 25 Contribution Margin Method The contribution margin method is a variation of the equation method. Fixed costs Fixed costs Unit contribution margin Unit contribution margin= Break-even point in units sold

27. 6 Slide 26 Contribution Margin Method The contribution margin method is a variation of the equation method. Fixed costs Fixed costs Unit contribution margin Unit contribution margin= Break-even point in units sold $80,000 $80,000 $200 $200 = 400 bikes

28. 6 Slide 27 Contribution Margin Method We can calculate the break-even point in total sales dollars as follows:

29. 6 Slide 28 Contribution Margin Method We can calculate the break-even point in total sales dollars as follows: Fixed costs Fixed costs CM ratio CM ratio= Break-even point in total sales dollars

30. 6 Slide 29 Contribution Margin Method We can calculate the break-even point in total sales dollars as follows: Fixed costs Fixed costs CM ratio CM ratio= Break-even point in total sales dollars $80,000 $80,000 40% 40% = $200,000 sales

31. 6 Slide 30 CVP Relationships in Graphic Form F Viewing CVP relationships in a graph gives managers a perspective that can be obtained in no other way. F Consider the following information for Sakuraba Co.:

32. 6 Slide 31 CVP Graph Fixed costs Units Dollars $80,000

33. 6 Slide 32 CVP Graph Units Dollars Variable costs $300/unit X $90,000/300 units

34. 6 Slide 33 CVP Graph Total costs Units Dollars $80,000 + $300X

35. 6 Slide 34 CVP Graph Total Sales Units Dollars $500/unit X$150,000/300 units

36. 6 Slide 35 CVP Graph Break-even point Units Dollars Y = a + bX Price X a + bX = Price X

37. 6 Slide 36 CVP Graph $80,000 + $300/unit (400 units) = $500/unit (400 units) = $200,000 Units Dollars Y = a + bX Price X

38. 6 Slide 37 CVP Graph Break-even point 400 units or $200,000 sales. Units Dollars Y = a + bX Price X

39. 6 Slide 38 Let’s Test Your Understanding!

40. 6 Slide 39 Basics of CVP Analysis 1. What does CVP stand for? 2. Compare the Traditional and Contribution Income Statement. Cost-Volume-Profit Sales -CGS -VarExp GM CM -S&A-Fixed Exp NI NI

41. 6 Slide 40 Break-Even Analysis 1. The Contribution Ratio = ________________________________. 2. At Break-Even, fixed costs = ________________________. 3. At Break-Even, sales = ________________________________. 4. Units at Break-Even = ________________________. 5. Sales at Break-Even = ________________________. Total CM/Sales or CM per unit/Price Sales - Var Exp. = CM Total Exp = Fixed Exp. + Var. Exp Fixed Exp./CM per unit Fixed Exp./CM%

42. 6 Slide 41 Exercise 1 Pringle Company manufactures and sells a single product. The company’s sales and costs for a recent month follow: 1. What is the monthly break-even point in units sold and in sales dollars? 2. Without resorting to computations, what is the total contribution margin at the break-even point. 3. What is the company’s CM ratio? If monthly sales increase by $80,000 and there is no change in fixed costs, by how much would you expect monthly net income to increase.

43. 6 Slide 42 Exercises 1 1. What is the monthly break-even point in units sold and in sales dollars? S/uX = VC/uX + Fixed costs + Profits $40X = $28X + $150,000 + $0 $12X = $150,000 X = $150,000/$12 X = 12,500 units 12,500 units x $40/u = $500,000 2. Without resorting to computations, what is the total contribution margin at the break-even point. The fixed cost of $150,000, which would yield a profit of zero. 3a. Determine the CM ratio? CM ratio = CM/Sales = $180,000/$600,000 = 30% 3b. If monthly sales increase by $80,000, by how much would you expect monthly net income to increase CM ratio X Sales = 30% X $80,000 = $24,000

44. 6 Slide 43 Exercise 2 Super Sales Company is the exclusive distribution for a new product. The product sells for $60 per unit and has a CM ratio of 40%. The company’s fixed costs are $360,000 per year. 1. What are the contribution margin & variable costs per unit? 2. Using the equation method: a. What is the break-even point in units and in sales dollars? CM per unit = $60 x 40% = $24 Variable exp. per unit : $60 x (100% - 40%) = $36 S/uX = VC/uX + Fixed costs + Profits $60X = $36X + $360,000 + $0 X = 15,000 units or Fixed costs/CM per unit = $360,000/$24 per unit = 15,000 units Sales@BE = PriceX = $60/unit (15,000 units) = $900,000 or Sales@BE = Fixed costs/CM ratio = $360,000/40%= $900,000

45. 6 Slide 44 Target Net Profit Analysis Suppose Sakuraba Co. wants to know how many bikes must be sold to earn a profit of $100,000. We can use our CVP formula to determine the sales volume needed to achieve a target net profit figure.

46. 6 Slide 45 The CVP Equation S/uX = VC/uX + Fixed costs + Profits

47. 6 Slide 46 The CVP Equation S/uX = VC/uX + Fixed costs + Profits $500X = $300X + $80,000 + $100,000 Where: X = Number of bikes sold $500 = Unit sales price $300 = Unit variable cost $80,000 = Total fixed costs $100,000 = Target net income

48. 6 Slide 47 The CVP Equation S/uX = VC/uX + Fixed costs + Profits $500X = $300X + $80,000 + $100,000 $200X = $180,000

49. 6 Slide 48 The CVP Equation S/uX = VC/uX + Fixed costs + Profits $500X = $300X + $80,000 + $100,000 $200X = $180,000 X = 900 bikes

50. 6 Slide 49 The Contribution Margin Approach We can determine the number of bikes that must be sold to earn a profit of $100,000 using the contribution margin approach.

51. 6 Slide 50 The Contribution Margin Approach We can determine the number of bikes that must be sold to earn a profit of $100,000 using the contribution margin approach. Fixed costs + Target profit Unit contribution margin = Units sold to attain the target profit

52. 6 Slide 51 The Contribution Margin Approach We can determine the number of bikes that must be sold to earn a profit of $100,000 using the contribution margin approach. Fixed costs + Target profit Unit contribution margin = Units sold to attain the target profit $80,000 + $100,000 $200 = 900 bikes

53. 6 Slide 52 The Concept of Sales Mix F For a company with more than one product, sales mix is the relative combination in which a company’s products are sold. F Different products have different selling prices, cost structures, and contribution margins. Let’s assume Sakuraba sells bikes and carts and see how we deal with break-even analysis.

54. 6 Slide 53 The Concept of Sales Mix Sakuraba provides us with the following information:

55. 6 Slide 54 The Concept of Sales Mix Find breakeven point in total units. $1,320,000____=120,000 units $1,320,000____ =120,000 units (1/3)$7 + (2/3)$13 (1/3)$7 + (2/3)$13

56. 6 Slide 55 The Concept of Sales Mix Separate total units by product mix. Bikes: 120,000 x 1/3 = 40,000 units Carts: 120,000 x 2/3 = 80,000 units Total 120,000 units

57. 6 Slide 56 The Margin of Safety or Safety Margin F Excess of budgeted (or actual) sales over the break-even volume of sales F Amount by which sales can drop before losses begin to be incurred

58. 6 Slide 57 The Margin of Safety F Excess of budgeted (or actual) sales over the break-even volume of sales. F Amount by which sales can drop before losses begin to be incurred. Total sales - Break-even sales = Margin of safety

59. 6 Slide 58 The Margin of Safety F Excess of budgeted (or actual) sales over the break-even volume of sales. F Amount by which sales can drop before losses begin to be incurred. Let’s calculate the margin of safety for Sakuraba. Total sales - Break-even sales = Margin of safety

60. 6 Slide 59 The Margin of Safety Sakuraba has a break-even point of $200,000. If actual sales are $250,000, the margin of safety is $50,000 or 100 bikes.

61. 6 Slide 60 The Margin of Safety 20 percent The margin of safety can be expressed as 20 percent of sales... ($50,000 ÷ $250,000)