COST VOLUME PROFIT ANALYSIS

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Chapter 7Chapter 7

Cost-Volume-Profit AnalysisCost-Volume-Profit Analysis

7-2

The Break-Even PointThe Break-Even Point

The break-even point is the point in the volume of activity where the organization’s

revenues and expenses are equal.

Sales 250,000$ Less: variable expenses 150,000 Contribution margin 100,000 Less: fixed expenses 100,000 Net income -$

Sales 250,000$ Less: variable expenses 150,000 Contribution margin 100,000 Less: fixed expenses 100,000 Net income -$

7-3

Equation ApproachEquation Approach

Sales revenue – Variable expenses – Fixed expenses = Profit

UnitUnitsalessalespriceprice

SalesSalesvolumevolumein unitsin units

××UnitUnit

variablevariableexpenseexpense

SalesSalesvolumevolumein unitsin units

××

($500 × X)× X) ($300 × X)× X)–– –– $80,000 = $0

($200X)X) –– $80,000 = $0

X = 400 surf boardsX = 400 surf boards

7-4

Contribution-Margin ApproachContribution-Margin Approach

For each additional surf board sold, Curl generates $200 in contribution margin.

Total Per Unit PercentSales (500 surf boards) 250,000$ 500$ 100%Less: variable expenses 150,000 300 60%Contribution margin 100,000$ 200$ 40%

Less: fixed expenses 80,000 Net income 20,000$



Consider the following information developed by the accountant at Curl, Inc.:

7-5


Fixed expensesFixed expenses Unit contribution margin Unit contribution margin ==

Break-even pointBreak-even point(in units)(in units)





$$80,00080,000 $$200200

== 400 surf boards400 surf boards

7-6


Here is the proof!


Less: fixed expenses 80,000 Net income -$



400 × $500 = $200,000400 × $500 = $200,000 400 × $300 = $120,000400 × $300 = $120,000

7-7

Contribution Margin RatioContribution Margin Ratio

Calculate the break-even point in sales dollars rather than units by using the contribution margin ratio.

Contribution margin Sales

= CM Ratio

Fixed expenseFixed expense CM RatioCM Ratio

Break-even pointBreak-even point(in sales dollars)(in sales dollars)==

7-8





Contribution Margin RatioContribution Margin Ratio

$80,000$80,000 40%40%

$200,000 sales$200,000 sales==

7-9

Graphing Cost-Volume-Profit Graphing Cost-Volume-Profit RelationshipsRelationships

Viewing CVP relationships in a graph gives managers a perspective that can be obtained in no other way.

Consider the following information for Curl, Inc.:

7-10

Cost-Volume-Profit GraphCost-Volume-Profit GraphD

olla

rs

600 700 800Units

200 300 400 500

450,000

100

200,000

150,000

100,000

50,000

400,000

350,000

300,000

250,000

Fixed expenses

7-11


olla

rs

600 700 800Units

200 300 400 500

450,000

100

200,000

150,000

100,000

50,000

400,000

350,000

300,000

250,000

Fixed expensesTotal expenses

7-12


olla

rs

600 700 800Units

200 300 400 500

450,000

100

200,000

150,000

100,000

50,000

400,000

350,000

300,000

250,000


7-13


olla

rs

600 700 800Units

200 300 400 500

450,000

100

200,000

150,000

100,000

50,000

400,000

350,000

300,000

250,000


Total sales

7-14


olla

rs

600 700 800Units

200 300 400 500

450,000

100

200,000

150,000

100,000

50,000

400,000

350,000

300,000

250,000


Total sales

Break-evenpoint

Break-evenpoint Profit a

rea

Loss area

7-15

Profit-Volume GraphProfit-Volume GraphSome managers like the profit-volume

graph because it focuses on profits and volume.Some managers like the profit-volume

graph because it focuses on profits and volume.

`

100 200 300 400 500 600 700Units

Pro

fit

0

100,000

(20,000)

(40,000)

(60,000)

80,000

60,000

40,000

20,000

Loss area

Profit areaBreak-even

pointBreak-even

point

7-16

Target Net ProfitTarget Net Profit

We can determine the number of surfboards that Curl must sell to earn a profit of $100,000

using the contribution margin approach.

We can determine the number of surfboards that Curl must sell to earn a profit of $100,000

using the contribution margin approach.

Fixed expenses + Target profit Unit contribution margin

=Units sold to earnthe target profit

$80,000 + $100,000 $200 $80,000 + $100,000 $200

= 900 surf boards= 900 surf boards

7-17

Equation ApproachEquation Approach

Sales revenue – Variable expenses – Fixed expenses = Profit

($500 × X)× X) ($300 × X)× X)–– –– $80,000 = $100,000$100,000$80,000 = $100,000$100,000

($200X)X) = $180,000= $180,000

X = 900 surf boardsX = 900 surf boards

7-18

Applying CVP AnalysisApplying CVP Analysis

Safety Margin• The difference between budgeted sales

revenue and break-even sales revenue.

• The amount by which sales can drop before losses begin to be incurred.

Safety Margin• The difference between budgeted sales

revenue and break-even sales revenue.

• The amount by which sales can drop before losses begin to be incurred.

7-19

Safety MarginSafety Margin

Curl, Inc. has a break-even point of $200,000. If actual sales are $250,000, the safety margin is $50,000 or 100 surf boards.

7-20

Changes in Fixed CostsChanges in Fixed Costs

• Curl is currently selling 500 surfboards per year.

• The owner believes that an increase of $10,000 in the annual advertising budget, would increase sales to 540 units.

Should the company increase the advertising budget?

• Curl is currently selling 500 surfboards per year.

• The owner believes that an increase of $10,000 in the annual advertising budget, would increase sales to 540 units.

Should the company increase the advertising budget?

7-21


$80,000 + $10,000 advertising = $90,000$80,000 + $10,000 advertising = $90,000

540 units × $500 per unit = $270,000540 units × $500 per unit = $270,000

7-22


Sales will increase by $20,000, but net income

decreaseddecreased by $2,000..

Sales will increase by $20,000, but net income

decreaseddecreased by $2,000..

7-23

Changes in UnitChanges in UnitContribution MarginContribution Margin

Because of increases in cost of raw materials, Curl’s variable cost per unit has increased from $300 to $310 per surfboard. With no

change in selling price per unit, what will be the new break-even point?

Because of increases in cost of raw materials, Curl’s variable cost per unit has increased from $300 to $310 per surfboard. With no

change in selling price per unit, what will be the new break-even point?

($500 × X)× X)($500 × X)× X) ($310 × X)× X)($310 × X)× X)–– – $80,000 = $0$80,000 = $0

X = 422 units X = 422 units (rounded)(rounded)

7-24

Changes in UnitChanges in UnitContribution MarginContribution Margin

Suppose Curl, Inc. increases the price of each surfboard to $550. With no change in variable cost per unit, what will be the

new break-even point?

Suppose Curl, Inc. increases the price of each surfboard to $550. With no change in variable cost per unit, what will be the

new break-even point?

($550 × X)× X)($550 × X)× X) ($300 × X)× X)($300 × X)× X)–– – $80,000 = $0$80,000 = $0

X = 320 units X = 320 units

7-25

Predicting Profit Given Expected Predicting Profit Given Expected VolumeVolume

Fixed expensesUnit contribution marginTarget net profit

Find: {req’d sales volume}Given:Given:

Fixed expensesUnit contribution marginExpected sales volume

Find: {expected profit}Given:Given:

7-26

Predicting Profit GivenPredicting Profit GivenExpected VolumeExpected Volume

In the coming year, Curl’s owner expects to sell 525 surfboards. The unit contribution margin is

expected to be $190, and fixed costs are expected to increase to $90,000.

In the coming year, Curl’s owner expects to sell 525 surfboards. The unit contribution margin is

expected to be $190, and fixed costs are expected to increase to $90,000.

($190 × 525)× 525)($190 × 525)× 525) – $90,000 = X$90,000 = X

X = $9,750 profit

X = $99,750 – $90,000

Total contribution - Fixed cost = ProfitTotal contribution - Fixed cost = Profit

7-27

CVP Analysis with Multiple CVP Analysis with Multiple ProductsProducts

For a company with more than one product, sales mix is the relative combination in which a

company’s products are sold.

Different products have different selling prices, cost structures, and contribution margins.

Let’s assume Curl sells surfboards and sail boards and see how we deal with break-

even analysis.

For a company with more than one product, sales mix is the relative combination in which a

company’s products are sold.

Different products have different selling prices, cost structures, and contribution margins.

Let’s assume Curl sells surfboards and sail boards and see how we deal with break-

even analysis.

7-28


Curl provides us with the following information:

7-29


Weighted-average unit contribution margin

$200 × 62.5%$200 × 62.5%

$550 × 37.5%$550 × 37.5%

7-30


Break-even pointBreak-evenpoint

= Fixed expenses

Weighted-average unit contribution margin

Break-evenpoint

= $170,000

$331.25

Break-evenpoint

= 514 combined unit sales514 combined unit sales

7-31


Break-even pointBreak-even

point= 514 combined unit sales

7-32

Assumptions UnderlyingAssumptions UnderlyingCVP AnalysisCVP Analysis

1. Selling price is constant throughout the entire relevant range.

2. Costs are linear over the relevant range.

3. In multi-product companies, the sales mix is constant.

4. In manufacturing firms, inventories do not change (units produced = units sold).

1. Selling price is constant throughout the entire relevant range.

2. Costs are linear over the relevant range.

3. In multi-product companies, the sales mix is constant.

4. In manufacturing firms, inventories do not change (units produced = units sold).

7-33

CVP Relationships and CVP Relationships and the Income Statementthe Income Statement

A. Traditional Format

Sales $500,000Less: 380,000Gross margin $120,000Less: Operating expenses:Selling expenses $35,000Administrative expenses 35,000 70,000Net income $50,000

ACCUTIME COMPANYIncome Statement

For the Year Ended December 31, 20x1

7-34

CVP Relationships and CVP Relationships and the Income Statementthe Income Statement

B. Contribution Format

Sales $500,000Less: Variable expenses:Variable manufacturing $280,000Variable selling 15,000Variable administrative 5,000 300,000Contribution margin $200,000Less: Fixed expenses:Fixed manufacturing $100,000Fixed selling 20,000Fixed administrative 30,000 150,000Net income $50,000

Income StatementFor the Year Ended December 31, 20x1

ACCUTIME COMPANY

7-35

Cost Structure and Operating Cost Structure and Operating LeverageLeverage

• The cost structure of an organization is the relative proportion of its fixed and variable costs.

• Operating leverage is . . .– the extent to which an organization uses fixed

costs in its cost structure.

– greatest in companies that have a high proportion of fixed costs in relation to variable costs.

• The cost structure of an organization is the relative proportion of its fixed and variable costs.

• Operating leverage is . . .– the extent to which an organization uses fixed

costs in its cost structure.

– greatest in companies that have a high proportion of fixed costs in relation to variable costs.

7-36

Measuring Operating LeverageMeasuring Operating Leverage

Contribution margin Net income

Operating leveragefactor

=

$100,000$100,000 $20,000$20,000

= 5= 5

7-37


A measure of how a percentage change in sales will affect profits. If Curl increases its sales by 10%, what will be the percentage

increase in net income?

A measure of how a percentage change in sales will affect profits. If Curl increases its sales by 10%, what will be the percentage

increase in net income?

Percent increase in sales 10%Operating leverage factor × 5Percent increase in profits 50%

Percent increase in sales 10%Operating leverage factor × 5Percent increase in profits 50%

7-38


A firm with proportionately high fixed costs has relatively high operating leverage On the other hand, a firm with high operating leverage has a relatively high break-even point.

7-39

CVP Analysis, Activity-Based Costing, CVP Analysis, Activity-Based Costing, and Advanced Manufacturing Systemsand Advanced Manufacturing SystemsAn activity-based costing system can provide

a much more complete picture of cost-volume-profit relationships and thus provide

better information to managers.

Break-evenBreak-evenpointpoint

== Fixed costsFixed costs Unit contribution marginUnit contribution margin

7-40

Overhead costs like setup, inspection, and material handling are fixed with respect to sales volume, but they are not fixed with respect to other cost

drivers.

This is the fundamental distinction between a traditional CVP analysis and an activity-based

costing CVP analysis.

Overhead costs like setup, inspection, and material handling are fixed with respect to sales volume, but they are not fixed with respect to other cost

drivers.

This is the fundamental distinction between a traditional CVP analysis and an activity-based

costing CVP analysis.

A Move Toward JIT andA Move Toward JIT andFlexible ManufacturingFlexible Manufacturing

7-41

Effect of Income TaxesEffect of Income Taxes

Target after-tax net income 1 - t

=Before-tax net income

Income taxes affect a company’s CVP relationships. To earn a

particular after-tax net income, a greater before-tax income will be

required.

7-42

End of Chapter 7End of Chapter 7

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COST VOLUME PROFIT ANALYSIS