1. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cost-Volume-Profit Analysis Lecture 15

2. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 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?  What will happen to profitability if I expand capacity? 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?  What will happen to profitability if I expand capacity? Questions Addressed by Cost-Volume-Profit Analysis

3. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 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. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 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. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 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. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 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, 10 cents per minute. Variable Cost Per Unit

7. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cost Behavior Summary

8. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 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. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Variable Utility Charge Activity (Kilowatt Hours) Total Utility Cost Total mixed cost Fixed Monthly Utility Charge Slope is variable cost per unit of activity. Mixed Costs

10. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Activity Cost Total cost remains constant within a narrow range of activity. Stair-Step Costs

11. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Activity Cost Total cost increases to a new higher cost for the next higher range of activity. Stair-Step Costs

12. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Total Cost Relevant Range A straight line closely (constant unit variable cost) approximates a curvilinear variable cost line within the relevant range. Volume of Output Curvilinear Cost Function Curvilinear Costs

13. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Let’s extend our knowledge of cost behavior to CVP analysis. Cost-Volume-Profit (CVP) Analysis

14. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin The break-even point (expressed in units of product or dollars of sales) is the unique sales level at which a company neither earns a profit nor incurs a loss. Computing Break-Even Point

15. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Contribution margin is amount by which revenue exceeds the variable costs of producing the revenue. Computing Break-Even Point

16. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin How much contribution margin must this company have to cover its fixed costs (break even)? Computing Break-Even Point

17. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin How much contribution margin must this company have to cover its fixed costs (break even)? Answer: $30,000 How much contribution margin must this company have to cover its fixed costs (break even)? Answer: $30,000 Computing Break-Even Point

18. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin How many units must this company sell to cover its fixed costs (break even)? Computing Break-Even Point

19. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin How many units must this company sell to cover its fixed costs (break even)? Answer: $30,000 ÷ $20 per unit = 1,500 units 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

20. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 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 Finding the Break-Even Point Unit sales price less unit variable cost ($20 in previous example) Formula for Computing Break-Even Sales (in Units)

21. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin The break-even formula may also be expressed in sales dollars. Break-even point in dollars = Fixed costs Contribution margin ratio Unit sales price Unit variable cost Formula for Computing Break-Even Sales (in Dollars)

22. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 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 Sales Question 1

23. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 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 Sales Question 1

24. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 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 Sales Question 2

25. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 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 Sales Question 2

26. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Volume in Units Costs and Revenue in Dollars Revenue  Starting at the origin, draw the total revenue line with a slope equal to the unit sales price. Total fixed cost  Total fixed cost extends horizontally from the vertical axis. Preparing a CVP Graph

27. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Total cost Volume in Units Costs and Revenue in Dollars Total fixed cost Break- even Point Profit Loss  Draw the total cost line with a slope equal to the unit variable cost. Revenue Preparing a CVP Graph

28. © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Source: Adopted from McGraw-Hill/Irvin