COST-VOLUME-PROFIT ANALYSIS



ACCTG 505 -- CHAPTER 3

COST-VOLUME-PROFIT ANALYSIS

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Introduction

Basic Planning Tool -- Answers “what if?” questions.

Examines behavior of total revenues, total costs, and operating income as changes occur in output level, selling price, variable costs per unit, and/or fixed costs.

50% surveyed companies use some form

Underlying Assumptions Show Fragility of Model

➢ Volume of units produced and sold is the only driver affecting changes in revenue and costs

➢ Total costs can be divided into fixed and variable components.

➢ All costs and revenues are linear

➢ Unit SP, VC, and total fixed costs are known and constant

➢ Sales mix, if multi-product company, remains constant

➢ Inventories are kept constant or at zero

➢ There is a relevant range of volume within which the above assumptions are valid

➢ Time value of money not usually considered

Mechanics

Income = ƒ[SP, Q, VC, FC] + [“Other stuff]

Contribution Margin income statement:

Sales (10,000 units @$80/unit $800,000

Less All Variable Costs (1,000 @ $48/unit) 480,000

Contribution Margin $320,000

Less All fixed costs 180,000

Operating Income $ 140,000

Contribution Margin: --

Contribution Margin Ratio: --

Use to determine following:

✓ Breakeven sales in units and in dollars

✓ Sales needed to determine target net income

✓ Indifference point between options

✓ Alternative cost structure models

✓ Multi-product breakeven and target income

Breakeven in Units

(USP x Q) – (UVC x Q) – FC = OI

Essentially boils down to this --

Fixed Costs/UCM = Breakeven in Units

Fixed Costs/CM Ratio = Breakeven in $ sales

Graph Approach – Plot total revenue, total costs. Intersection point of two lines is BE. CVP graph shown

Total $

Quantity in units

Profit-Volume Graph: Shows operating income at different volume levels

Operating income $

$0

Units

B. Target Net Income

(Fixed Costs + BEFORE TAX Income)/CM or CM%

Assume example company has tax rate of 35%. How many units must be sold to achieve an after-tax income of $100,000?

1.

2.

3.

C. Sensitivity Analysis: -- How will results change if predicted data not achieved or an underlying assumption changes?

What if unit SP or VC change? CM and BE will change

What if fixed costs change? BE will change

By how much can sales fall before hit BE? Margin of safety

D. Indifference Point:

At what volume level is there no difference between the options being examined?

Alternative 1. USP $80, UVC $48, FC $260,000

Alternative 2 USP $80, UVC $30, FC $440,000

Significance of Above?

1.

2.

What factors would influence your choice?

E. Operating Leverage

The extent to which fixed costs are used to leverage operating profit.

The higher the fixed costs and lower the unit variable cost, the higher the operating leverage a company is using.

The greater the use of operating leverage (i.e. relatively high fixed costs), the larger the increase in profits as sales rise; however, the downside is larger decrease in profits if sales decline.

Degree of reliance on operating leverage reflects management’s tolerance for risk.

Multi-Product Computations

Example: USP is $100; VC per unit is $60

USP is $120; VC per unit is $70

Sales Mix is 3 of B for every unit of A sold

Total fixed costs are $30,000

What is breakeven point in total units and units of A and B?

III. Which Margins? (Managerial vs. Financial Objectives.)

CM income statement emphasizes contribution margin. Classifies costs according to behavior.

• Sales less Variable Cost of Goods Sold less Variable Non-manufacturing costs = Contribution Margin

• Contribution Margin less Fixed Manufacturing and Fixed Operating Costs = Operating Income

Financial accounting income statement emphasizes gross margin. Classifies costs according to business functions.

• Sales less Cost of Goods Sold (fixed and variable manufacturing costs – i.e. product costs) = Gross Margin

• Gross Margin less Operating Costs (non-manufacturing fixed and variable – i.e. period costs) = Operating Income

Although it has several advantages over GAAP reporting, the CM income statement is not allowed for external reporting purposes.

Why?

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CVP Analysis

Looks at what we can control to make predictions

(competition

(economic issues

(government reg.

No control over, may overpower CVP analysis

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