1. Copyright © 2008 Prentice Hall All rights reserved 7-1 Cost-Volume-Profit Analysis Chapter 7

2. Copyright © 2008 Prentice Hall All rights reserved 7-2 Objective 1 Calculate the unit contribution margin and the contribution margin ratio

3. Copyright © 2008 Prentice Hall All rights reserved 7-3 Components of CVP Analysis Sales price per unit Volume sold Variable costs per unit Fixed costs Operating income

4. Copyright © 2008 Prentice Hall All rights reserved 7-4 CVP Assumptions 1.Change in volume is only factor that affects costs 2.Managers 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 © 2008 Prentice Hall All rights reserved 7-5 Unit Contribution Margin Sales price per unit - Variable costs per unit Contribution margin per unit Example: Sales Price per Poster $35 Less: Variable Cost per poster (21) Contribution Margin per poster $14

6. Copyright © 2008 Prentice Hall All rights reserved 7-6 Contribution Margin Ratio Unit contribution margin Sales price per unit Example: Unit contribution margin $14 = 40% Sales price per unit $35

7. Copyright © 2008 Prentice Hall All rights reserved 7-7 Objective 2 Use CVP analysis to find breakeven points and target profit volumes

8. Copyright © 2008 Prentice Hall All rights reserved 7-8 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 © 2008 Prentice Hall All rights reserved 7-9 Income Statement Approach Contribution Margin Income Statement Sales - Variable Costs Contribution Margin - Fixed Costs Operating Income

10. Copyright © 2008 Prentice Hall All rights reserved 7-10 Short-Cut Approach Using the Unit Contribution Margin Fixed expenses + Operating income Contribution margin per unit Units sold =

11. Copyright © 2008 Prentice Hall All rights reserved 7-11 Short-Cut Approach Using the Unit Contribution Margin Ratio Fixed expenses + Operating income Contribution margin ratio Sales in $ =

12. Copyright © 2008 Prentice Hall All rights reserved 7-12 E7-15 1. Contribution margin ratio = Contribution margin ÷ Sales = $187,500 ÷ $312,500 = 60%

13. Copyright © 2008 Prentice Hall All rights reserved 7-13 E7-15 1. Aussie Travel Contribution Margin Income Statements Sales revenue$250,000$360,000 Variable expenses (40%) 100,000144,000 Contribution margin$?$? Fixed expenses 170,00170,000 Operating income (loss)$ (20,000)$46,000 Hint: Contribution margin income statements are produced by using the different volume levels and the calculated variable expenses.

14. Copyright © 2008 Prentice Hall All rights reserved 7-14 E7-15 2. Fixed expenses + Operating income Contribution margin ratio Sales in $ = $170,000 + $0 60% Sales in $ = = $283,333

15. Copyright © 2008 Prentice Hall All rights reserved 7-15 E7-17 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 © 2008 Prentice Hall All rights reserved 7-16 E7-17 2. Breakeven sales in units: Fixed costs + Operating income ? ($85,000 + $0) / ? = 100,000 units

17. Copyright © 2008 Prentice Hall All rights reserved 7-17 E7-17 2. Breakeven sales in dollars: Fixed costs + Operating income Contribution margin ratio ($85,000 + $0) / 50% = $170,000

18. Copyright © 2008 Prentice Hall All rights reserved 7-18 E7-17 3. Sales in units: Fixed costs + Operating income Contribution margin per unit ($85,000 + $25,000) / $0.85 = 129,412 units

19. Copyright © 2008 Prentice Hall All rights reserved 7-19 Graphing the CVP Relationships Step 1:  Choose a sales volume  Plot point for total sales revenue  Draw sales revenue line from origin through the plotted point

20. Copyright © 2008 Prentice Hall All rights reserved 7-20 Preparing a CVP Chart

21. Copyright © 2008 Prentice Hall All rights reserved 7-21 Preparing a CVP Chart Step 2:  Draw the fixed cost line

22. Copyright © 2008 Prentice Hall All rights reserved 7-22 Preparing a CVP Chart

23. Copyright © 2008 Prentice Hall All rights reserved 7-23 Preparing a CVP Chart Step 3:  Draw the total cost line Hint: What are the two factors that comprise the Total Cost of operations?

24. Copyright © 2008 Prentice Hall All rights reserved 7-24 Preparing a CVP Chart

25. Copyright © 2008 Prentice Hall All rights reserved 7-25 Preparing a CVP Chart Step 4:  Identify the breakeven point and the areas of operating income and loss Hint: When does a company “break even”? When the neither make money or lose money….

26. Copyright © 2008 Prentice Hall All rights reserved 7-26 Preparing a CVP Chart Breakeven point

27. Copyright © 2008 Prentice Hall All rights reserved 7-27 Preparing a CVP Chart Step 5:  Mark operating income and operating loss areas on graph

28. Copyright © 2008 Prentice Hall All rights reserved 7-28 Preparing a CVP Chart Breakeven point Operating income Operating Loss

29. Copyright © 2008 Prentice Hall All rights reserved 7-29 E7-24 Revenues

30. Copyright © 2008 Prentice Hall All rights reserved 7-30 E7-24 Fixed Costs Revenues

31. Copyright © 2008 Prentice Hall All rights reserved 7-31 E7-24 Breakeven point Total Costs Fixed Costs Revenues

32. Copyright © 2008 Prentice Hall All rights reserved 7-32 Operating Loss Operating income E7-24 Total Costs Revenues

33. Copyright © 2008 Prentice Hall All rights reserved 7-33 E7-24 ($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 © 2008 Prentice Hall All rights reserved 7-34 Objective 3 Perform sensitivity analysis in response to changing business conditions

35. Copyright © 2008 Prentice Hall All rights reserved 7-35 Sensitivity Analysis “What if” analysis What if the sales price changes? What if costs change? What if the sales mix changes?

36. Copyright © 2008 Prentice Hall All rights reserved 7-36 E7-25 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 © 2008 Prentice Hall All rights reserved 7-37 E7-25 Sales needed to Breakeven = Fixed Costs ÷ Contribution Margin Ratio $240,000 ÷.40 = $600,000

38. Copyright © 2008 Prentice Hall All rights reserved 7-38 E7-26 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 © 2008 Prentice Hall All rights reserved 7-39 Objective 4 Find breakeven and target profit volumes for multiproduct companies

40. Copyright © 2008 Prentice Hall All rights reserved 7-40 Multiple Product Break-Even Point – E7-28 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 © 2008 Prentice Hall All rights reserved 7-41 Multiple Product Break-Even Point – E7-28 Step 2: Calculate the breakeven point in units Fixed costs + Operating income Weighted average contribution margin per unit (? + ?) ÷ ? = 440 composite units

42. Copyright © 2008 Prentice Hall All rights reserved 7-42 Multiple Product Break-Even Point – E7-28 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 © 2008 Prentice Hall All rights reserved 7-43 E7-28 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 © 2008 Prentice Hall All rights reserved 7-44 Objective 5 Determine a firm’s margin of safety and operating leverage

45. Copyright © 2008 Prentice Hall All rights reserved 7-45 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 as well as the risk of new plans

46. Copyright © 2008 Prentice Hall All rights reserved 7-46 Margin of Safety Margin of Safety in Units = Expected sales in units – Breakeven sales in units Margin of Safety in Dollars = Margin of safety in units x Sale price per unit

47. Copyright © 2008 Prentice Hall All rights reserved 7-47 Margin of Safety Margin on safety as a percentage is the same whether units or dollars are used Margin of safety in units ÷ Expected sales in units Margin of safety in dollars ÷ Expected sales in $

48. Copyright © 2008 Prentice Hall All rights reserved 7-48 E7-33 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 © 2008 Prentice Hall All rights reserved 7-49 E7-33 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 © 2008 Prentice Hall All rights reserved 7-50 E7-33 1. Margin of safety = Expected sales – breakeven sales = $70,000 - $30,000 = $40,000

51. Copyright © 2008 Prentice Hall All rights reserved 7-51 E7-33 2. Margin of safety as a % of target sales = $40,000 ÷ $70,000 = 57%

52. Copyright © 2008 Prentice Hall All rights reserved 7-52 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 © 2008 Prentice Hall All rights reserved 7-53 Characteristics of High Operating Leverage Firms High operating leverage companies have: –Higher levels of fixed costs and lower levels of variable costs –Higher contribution margin ratios For high operating leverage companies, changes in volume significantly affect operating income, so they also face: –Higher risk –Higher potential for reward Examples include: golf courses, hotels, rental car agencies, theme parks, airlines, cruise lines

54. Copyright © 2008 Prentice Hall All rights reserved 7-54 Characteristics of Low Operating Leverage companies Low operating leverage companies have: –Higher levels of variable costs, and lower levels of fixed costs –Lower contribution margin ratios For low operating leverage companies, changes in volume do NOT have as significant an affect on operating income, so they face: –Lower risk –Lower potential for reward Examples include: merchandising companies

55. Copyright © 2008 Prentice Hall All rights reserved 7-55 Operating Leverage Factor Contribution margin Operating income As a general rule, the operating leverage factor, at a given level of sales, indicates the percentage change in operating income that will occur from a 1% change in volume

56. Copyright © 2008 Prentice Hall All rights reserved 7-56 E7-33 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 © 2008 Prentice Hall All rights reserved 7-57 E7-33 4. If volume decreases 10%, income will decrease: 10% x 1.75 = 17.5%

58. Copyright © 2008 Prentice Hall All rights reserved 7-58 End of Chapter 7