1. Chapter 18 Cost volume profit analysis 18-1 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

2. Outline What is CVP analysis? The break-even point Graphing CVP relationships Target net profit Using CVP analysis for management decisions CVP analysis with multiple products Including income taxes in CVP analysis Practical issues in CVP analysis An activity-based approach to CVP analysis Financial planning models 18-2 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

3. Cost volume profit (CVP) analysis A technique used to determine the effects of changes in an organisation’s sales volume on its costs, revenue and profit Can be used in profit-seeking organisations and not-for-profit organisations 18-3 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

4. The break-even point The volume of sales where the total revenues and costs are equal, and the operation breaks even At this level of sales, there is no profit or loss Can be calculated for an entire organisation or for individual projects 18-4 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

5. Break-even formulas 18-5 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

6. Terminology Contribution margin (or variable costing) statement –An income statement that separates fixed and variable costs and calculates a contribution margin Total contribution margin –The difference between the total sales revenue and the total variable costs –The amount available to cover fixed costs and then contribute to profits Unit contribution margin –The difference between the sales price per unit and the variable cost per unit 18-6 (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

7. Terminology (cont.) Contribution margin ratio –The unit contribution margin divided by the unit sales price –The proportion of each sales dollar available to cover fixed costs and earn a profit Contribution margin percentage –The contribution margin ratio multiplied by 100 –The percentage of each sales dollar available to cover fixed costs and earn a profit 18-7 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

8. Graphing cost volume profit relationships Shows how costs, revenue and profits change as sales volume changes Five steps 1.Draw the axes of the graph 2.Draw the fixed cost line 3.Draw the total cost line 4.Draw the total revenue line 5.Break-even point—where the total revenue and total cost lines intersect 18-8 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

9. 18-9 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

10. Profit volume (PV) graph Shows the total amount of profit or loss at different sales volumes The graph intercepts the vertical axis at the amount equal to the fixed costs The break-even point is the point at which the total profit/loss line crosses the horizontal axis 18-10 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

11. 18-11 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

12. Target net profit A desired profit level determined by management The break-even formula can be sued to determine the target profit 18-12 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

13. Using CVP analysis for management decision making Safety margin –Difference between the budgeted sales revenue and break-even sales revenue –Gives a feel for how close projected operations are to the break-even point Changes in fixed costs –Percentage change in fixed costs will lead to a similar increase in the break-even point (in units or dollars) –Different fixed costs may apply to different levels of sales/production volume, and provide more than one break-even point 18-13 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith (cont.)

14. Using CVP analysis for management decision making (cont.) Changes in the unit contribution margin –Change in unit variable costs, leads to new –unit contribution margin and new break-even point –An increase in unit variable costs will increase the break- even point –An increase in unit price will lower the break-even point 18-14 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

15. Multiple changes in key variables May involve, for example –Increasing unit prices –Increasing selling prices –Undertaking a new advertising campaign –Leasing a new office An incremental approach to analysis –Focuses on the differences in the total contribution margin, fixed costs and profits under the two alternatives 18-15 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

16. CVP analysis with multiple products Sales mix –The relative proportions of each type of product sold by the organisation Weighted average unit contribution margin –The average of the products’ unit contribution margins, weighted by the sales mix 18-16 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

17. 18-17 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

18. Including income taxes in CVP analysis 18-18 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

19. Assumptions underlying CVP analysis The behaviour of total revenue is linear The behaviour of total costs is linear over a relevant range –Costs can be categorised as fixed, variable or semivariable –Labour productivity, production technology and market conditions do not change –There are no capacity changes during the period under consideration 18-19 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith (cont.)

20. Assumptions underlying CVP analysis (cont.) For both variable and fixed costs, sales volume is the only cost driver The sales mix remains constant over the relevant range In manufacturing firms, the levels of inventory at the beginning and end of the period are the same –Thus, the number of units produced and sold during a period are equal 18-20 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

21. CVP analysis and longer-term decisions CVP analysis is usually regarded as a short-term or tactical decision tool Classification of costs as variable or fixed is usually based on cost behaviour over the short term The financial impact of long-term decisions is best analysed using capital budgeting techniques –Takes into account the time value of money 18-21 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

22. Treating CVP analysis with caution CVP analysis is merely a simplified model The usefulness of CVP analysis may be greater in less complex smaller firms, or stand-alone projects For larger firms, CVP analysis can be valuable as a decision tool for the planning stages of new projects and ventures 18-22 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

23. An activity-based approach to CVP analysis ABC categorises activities as unit, batch, product or facility level –Facility, product and batch activities are non-volume activity costs 18-23 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

24. Limiting assumptions of CVP analysis using activity-based costs Total batch level costs are dependent on the batch size and the break-even/target production level Management may change the batch size at certain production volume levels and this will change the break-even volume More complex models are needed where there are multiple products 18-24 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

25. Financial planning models Sensitivity analysis and CVP analysis –An approach that examines how an outcome may change if there are variations in the predicted data or underlying assumptions Can be run using spreadsheet software, such as Excel Goal seek approaches –The analyst specifies the outcome, and the software specifies the necessary inputs What-if analysis –The analyst specifies changes in assumptions and data to examine the effect of these changes on the outputs 18-25 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

26. Summary CVP analysis is a decision tool that can be used to assess the effects on changes in profit of changes in sales volume, sales price, sales mix and costs The break-even point is the sales level at which sales covers costs—there are zero profits The break-even formula can be modified to calculate target profit, and to include sales mix and income taxes CVP analysis has several assumptions which limit its usefulness for decision making Activity-based approaches and financial planning modelling can provide more sophisticated models 18-26 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith