1. CVP Analysis

Download as pdf or txt
Download as pdf or txt
You are on page 1of 58

COST - VOLUME –

PROFIT ANALYSIS

Edited by
Nazim Uddin
Lecturer, National Institute of Textile
Engineering & Research
Study Objectives

1. Distinguish between
variable and fixed costs.
2. Explain the significance of
the relevant range.
3. Explain the concept of
mixed costs.
4. List the five components of
cost-volume-profit analysis.
5. Indicate what contribution
margin is and how it can be
expressed.
Study Objectives

6. Identify the three ways to


determine the break-even
point.
7. Give the formulas for
determining sales required
to earn target net income.
8. Define margin of safety,
and give the formulas for
computing it.
Preview of Chapter

To manage any business, you must understand:

How costs respond to changes in sales volume,


and
The effect of costs and revenues on profit.

To understand cost-volume-profit (CVP), you must


know how costs behave.
Cost-Volume-Profit

Cost Behavior Cost-Volume-


Analysis Profit Analysis

Variable costs Basic components


Fixed costs CVP income statement
Relevant range Break-even analysis
Mixed costs Target net income
Identifying Margin of safety
variable and fixed
costs
Cost Behavior Analysis

Cost Behavior Analysis is:


the study of how specific costs respond to
changes in the level of business activity.

Some costs change; others remain the same.

A knowledge of cost behavior helps management plan


operations and decide between alternative courses
of action.

Cost behavior analysis applies to all types of


entities.
Cost Behavior Analysis - Continued

Starting point in cost behavior analysis is


measuring key business activities.

Activity levels may be expressed in terms of:


Sales dollars (in a retail company).
Miles driven (in a trucking company).
Room occupancy (in a hotel).
Dance classes taught (by a dance studio).

Many companies use more than one


measurement base.
Cost Behavior Analysis - Continued
For an activity level to be useful:
Changes in the level or volume of activity
should be correlated with changes in costs.

The activity level selected is called the


activity or volume index.

The activity index:


Identifies the activity that causes changes in
the behavior of costs.
Allows costs to be classified according to their
response to changes in activity as either:
Variable Costs Fixed Costs Mixed Costs
Variable Costs

Variable costs are costs that vary in total directly


and proportionately with changes in the activity
level.

Example: If the activity level increases 10 percent, total


variable costs will increase 10 percent .
Example: If the activity level decreases by 25 percent,
total variable costs will decrease by 25 percent.

Variable costs remain the same per unit at every


level of activity.

SO 1: Distinguish between variable and fixed costs.


Variable Costs

Examples of Variable Costs:


1. Direct Materials.
2. Direct Labor.
3. Cost of Goods Sold.
4. Sales Commissions.
5. Freight-Out for a Merchandiser.
6. Gasoline at an Airline Company.

SO 1: Distinguish between variable and fixed costs.


Variable Costs – Example

Damon Company manufactures radios that


contain a $10 digital clock.

The activity index is the number of radios


produced.

For each radio produced, the total cost of the


clocks increases by $10:
If 2,000 radios are produced, the total cost of the
clocks is $20,000 (2,000 × $10).
If 10,000 radios are produced, the total cost of the
clocks is $100,000 (10,000 × $10).

SO 1: Distinguish between variable and fixed costs.


Variable Costs – Graphs

SO 1: Distinguish between variable and fixed costs.


Fixed Costs

Fixed costs are costs that remain the same in


total regardless of changes in the activity level.
Fixed costs per unit cost vary inversely with
activity:
As volume increases, unit cost declines, and
vice versa.

Examples include:
1. Depreciation on buildings and equipment,
2. Property taxes

3. Insurance, and
4. Rent.

SO 1: Distinguish between variable and fixed costs.


Fixed Costs - Example

Damon Company leases its productive facilities at a


cost of $10,000 per month.

Total fixed costs of the facilities remain constant


at every level of activity - $10,000 per month.

Fixed costs on a per unit basis vary inversely with


activity - as activity increases, unit cost declines
and vice versa.
At 2,000 radios, the unit cost is $5 ($10,000 ÷ 2,000 units).
At 10,000 radios, the unit cost is $1 ($10,000 ÷ 10,000 units).

SO 1: Distinguish between variable and fixed costs.


Fixed Costs - Graphs

SO 1: Distinguish between variable and fixed costs.


Let’s Review

Variable costs are costs that:

a. Vary in total directly and proportionately with


changes in the activity level.
b. Remain the same per unit at every activity level.
c. Neither of the above.
d. Both a and b above.

SO 1: Distinguish between variable and fixed costs.


Relevant Range

Throughout the range of possible levels of activity,


a straight-line relationship usually does not exist
for either variable costs or fixed costs.

The relationship between variable costs and


changes in activity level is often curvilinear.

For fixed costs, the relationship is also nonlinear –


some fixed costs will not change over the entire
range of activities while other fixed costs may
change.

SO 2: Explain the significance of the relevant range.


Relevant Range - Graphs

SO 2: Explain the significance of the relevant range.


Relevant Range

Defined as the range of activity over which a


company expects to operate during a year.

Within this range, a straight-line relationship


usually exists for both variable and fixed costs.

SO 2: Explain the significance of the relevant range.


Let’s Review

The relevant range is:

a. The range of activity in which variable costs will


be curvilinear.
b. The range of activity in which fixed costs will be
curvilinear.
c. The range over which the company expects to
operate during a year.
d. Usually from zero to 100% of operating capacity.

SO 2: Explain the significance of the relevant range.


Mixed Costs

Costs that have


both a variable
cost element
and a fixed
cost element.

Sometimes called
semivariable cost.

Change in total
but not
proportionately
with changes in
activity level.

SO 3: Explain the concept of mixed costs.


Mixed Costs: High–Low Method

For purposes of Cost-Volume-Profit (CVP)


analysis, mixed costs must be classified into their
fixed and variable elements.

One approach to separate the costs is called the


high-low method.

Uses the total costs incurred at the high and low


levels of activity to classify mixed costs into
fixed and variable components.

The difference in costs between the high and low


levels represents variable costs, since only
variable costs change as activity levels change.
SO 3: Explain the concept of mixed costs.
Mixed Costs:
Steps in High–Low-Method

STEP 1: Determine variable cost per unit using the


following formula:

STEP 2: Determine the fixed cost by subtracting


the total variable cost at either the high
or the low activity level from the total cost
at that level.

SO 3: Explain the concept of mixed costs.


Mixed Costs:
High–Low Method Example

Data for Metro Transit Company for 4 month period:

High Level of Activity: April $63,000 50,000 miles


Low Level of Activity: January 30,000 20,000 miles
Difference $33,000 30,000 miles

Step 1: Using the formula, variable costs per unit are:


$33,000  30,000 miles = $1.10 variable cost per mile.

SO 3: Explain the concept of mixed costs.


Mixed Costs:
High–Low-Method Example

Step 2: Determine the fixed costs by subtracting total


variable costs at either the high or low activity
level from the total cost at that same level.

SO 3: Explain the concept of mixed costs.


Mixed Costs:
High–Low-Method Example

Maintenance costs:
$8,000 per month plus $1.10 per mile.

To determine maintenance costs at a particular


activity level:
1. Multiply the activity level times the
variable cost per unit,
2. Then add that total to the fixed cost.

EXAMPLE: If the activity level is 45,000 miles, the


estimated maintenance costs would be $8,000 fixed
costs and $49,500 variable ($1.10 × 45,000 miles) for
a total of $57,500.
SO 3: Explain the concept of mixed costs.
Let’s Review

Mixed costs consist of a:

a. Variable cost element and a fixed cost


element.
b. Fixed cost element and a semi-variable cost
element.
c. Relevant cost element and a fixed cost
element.
d. Variable cost element and a relevant cost
element.

SO 3: Explain the concept of mixed costs.


Cost-Volume-Profit Analysis

CVP Analysis - the study of the effects


of changes in costs and volume on a
company’s profits.

Important in profit planning.

A critical factor in setting:


selling prices,
determining product mix, and
maximizing use of production facilities.

SO 4: List the five components of cost-volume-profit analysis.


Cost-Volume-Profit Analysis

CVP analysis considers the interrelationships


among five basic components:

SO 4: List the five components of cost-volume-profit analysis.


Assumptions Underlying CVP Analysis

1. Behavior of both costs and revenues is linear


throughout the relevant range of the activity
index.

2. Costs can be classified accurately as either variable


or fixed.

3. Changes in activity are the only factors that affect


costs.

4. All units produced are sold.


5. When more than one type of product is sold, the
sales mix will remain constant.
SO 4: List the five components of cost-volume-profit analysis.
Let’s Review

One of the following is NOT involved in CVP analysis.


That factor is:

a. Sales mix.
b. Unit selling prices.
c. Fixed costs per unit.
d. Volume or level of activity.

SO 4: List the five components of cost-volume-profit analysis.


CVP Income Statement

Classifies costs and expenses as fixed or variable.


Reports contribution margin in the body of the
statement.
Contribution margin –
Amount of revenue remaining
after deducting all variable costs.
Reports the same net
income as a traditional income statement.

A statement for internal use only.

SO 5: Indicate what contribution margin is and how it can be expressed.


CVP Income Statement - Example

Vargo Video Company produces a DVD player/recorder.


Relevant data for June 2010:

SO 5: Indicate what contribution margin is and how it can be expressed.


Contribution Margin Per Unit

Contribution margin is the amount available to cover fixed


costs and to contribute to income.
The formula for contribution margin per unit and the
computation of the contribution margin per unit for Vargo
Video are:

Thus, for every DVD player sold, Vargo Video has $200 to
cover fixed costs and contribute to net income.

SO 5: Indicate what contribution margin is and how it can be expressed.


CVP Income Statement – Contribution Margin Effect

Since Vargo Video has fixed costs of $200,000, it must sell


1,000 DVD players ($200,000 ÷ $200) before it can earn any
net income.
Vargo’s CVP income statement, assuming a zero net income is:

SO 5: Indicate what contribution margin is and how it can be expressed.


CVP Income Statement – Contribution Margin Effect

For every DVD player that Vargo sells above 1,000 units, net
income increases by the amount of the contribution margin,
$200.
Vargo’s CVP income statement, assuming 1001 units sold is:

SO 5: Indicate what contribution margin is and how it can be expressed.


Contribution Margin Ratio

Shows the percentage of each sales dollar available to apply


toward fixed costs and profits.
The contribution margin ratio is the contribution margin per
unit divided by the unit selling price. For Vargo Company, the
computation is:

In this case, the contribution margin ratio of 40% means


that $ 0.40 of each sales dollar is available to apply to fixed
costs and contribute to net income.

SO 5: Indicate what contribution margin is and how it can be expressed.


Contribution Margin Ratio

As shown below, the contribution margin ratio


helps to determine the effect of changes in sales
on net income.

SO 5: Indicate what contribution margin is and how it can be expressed.


Let’s Review

Contribution margin:

a. Is revenue remaining after deducting variable


costs.
b. May be expressed as contribution margin per
unit.
c. Is selling price less cost of goods sold.
d. Both a and b above.

SO 5: Indicate what contribution margin is and how it can be expressed.


Break-Even Analysis

A key relationship in CVP analysis is the level of activity at


which total revenue equals total costs (both fixed and
variable).
This level of activity is called the break-even point.

At this volume of sales, the company will realize no income, but


will also suffer no loss.

Can be computed or derived:


from a mathematical equation,
by using contribution margin, or
from a cost-volume profit (CVP) graph.

The break-even point can be expressed either in sales units or


in sales dollars.

SO 6: Identify the three ways to determine the break-even point.


Break-Even Analysis: Mathematical Equation

Break-even occurs where total sales equal variable


costs plus fixed costs; i.e., net income is zero.
The formula for the break-even point in units and
the computation for Vargo Video are:

To find sales dollars required to break-even:


1,000 units × $500 = $500,000 (break-even sales dollars).

SO 6: Identify the three ways to determine the break-even point.


Break-Even Analysis:
Contribution Margin Technique

At the break-even point, contribution margin must equal


total fixed costs.
(Contribution Margin = Total revenues – Variable costs)

The break-even point (BEP) can be computed using either


contribution margin per unit or contribution margin ratio.

SO 6: Identify the three ways to determine the break-even point.


Contribution Margin Technique

When the contribution margin per unit is used, the


formula to compute the BEP in units for Vargo Video
is:

When the BEP in dollars is desired, contribution


margin ratio is used in the following formula for
Vargo Video:

SO 6: Identify the three ways to determine the break-even point.


Break-Even Analysis: Graphic Presentation

A cost-volume profit (CVP) graph shows the


relationships between costs, volume and profits.
To construct a CVP graph:
Plot the total-sales line starting at the
zero activity level,
Plot the total fixed cost using a
horizontal line,
Plot the total-cost line (starts at the
fixed-cost line at zero activity),
Determine the break-even point from
the intersection of the total-cost
line and the total-sales line.

SO 6: Identify the three ways to determine the break-even point.


Break-Even Analysis: Graphic Presentation

SO 6: Identify the three ways to determine the break-even point.


Let’s Review

Gossen Company is planning to sell 200,000 pliers for


$4 per unit. The contribution margin ratio is 25
percent. If Gossen will break even at this level of
sales, what are the fixed costs?

a. $100,000.
b. $160,000.
c. $200,000.
d. $300,000.

SO 6: Identify the three ways to determine the break-even point.


Break-Even Analysis: Target Net Income

Rather than just breaking even, management usually


sets an income objective called “target net income.”
Indicates sales or units necessary to achieve this
specified level of income.
Can be determined from each of the approaches used
to determine break-even sales/units:
From a mathematical equation,
By using contribution margin, or
From a cost-volume profit (CVP) graph.
Expressed either in sales units or in sales dollars.
SO 7: Give the formulas for determining sales required
to earn target net income.
Break-Even Analysis: Target Net Income

Mathematical Equation
Using the basic formula for the break-even point,
simply include the desired net income as a factor.
The computation for Vargo Video is as follows:

SO 7: Give the formulas for determining sales required to


earn target net income.
Break-Even Analysis: Target Net Income

Contribution Margin Technique


To determine the required sales in units for Vargo
Video:

To determine the required sales in dollars for Vargo


Video:

SO 7: Give the formulas for determining sales required to


earn target net income.
Let’s Review

The mathematical equation for computing required


sales to obtain target net income is:
Required sales = ?

a. Variable costs + Target net income.


b. Variable costs + Fixed costs + Target net
income.
c. Fixed costs + Target net income.
d. No correct answer is given.

SO 7: Give the formulas for determining sales required to


earn target net income.
Break-Even Analysis: Margin of Safety

Difference between actual or expected sales and


sales at the break-even point.
Measures the “cushion” that management has,
allowing it to break-even even if expected sales fail
to materialize.
May be expressed in dollars or as a ratio.
To determine the margin of safety in dollars for
Vargo Video assuming that actual/expected sales are
$750,000:

SO 8: Define margin of safety, and give the formulas for computing it.
Break-Even Analysis: Margin of Safety

Margin of Safety Ratio


Computed by dividing the margin of safety in dollars
by the actual or expected sales.
To determine the margin of safety ratio for Vargo
Video assuming that actual/expected sales are
$750,000:

The higher the dollars or the percentage, the


greater the margin of safety.

SO 8: Define margin of safety, and give the formulas for computing it.
Let’s Review

Marshall Company had actual sales of $600,000 when


break-even sales were $420,000. What is the margin
of safety ratio?

a. 25%.
b. 30%.
c. 33 1/3%.
$600 - $420 = $180
d. 45%. $180 ÷ $600 = 30%

SO 8: Define margin of safety, and give the formulas for


computing it.
All About You

A Hybrid Dilemma
Hybrid vehicles typically cost
$3,000 to $5,000 more than
conventional vehicles.
The most fuel efficient
hybrids can save about $660
per year in fuel costs.
Each gallon of gas not burned
reduces carbon dioxide
emissions by 19 pounds.
All About You

A Hybrid Dilemma
What do you think?
Do you think that making the
investment in a hybrid car will
slow the cash outflow from
your wallet due to high gas
prices and save your feet?
Because of the premium
charged for hybrid cars,
would you ever break-even on
your investment?
Chapter Review - Brief Exercise 5-4
Markowis Company accumulates the following data concerning a
mixed cost, using miles as the activity level.
Miles Total Miles Total
Driven Cost Driven Cost
January 8,000 $14,150 March 8,500 $15,000
February 7,500 $13,600 April 8,200 $14,490

Compute the variable and fixed cost elements using the high-
low method.
High Level of Activity: March $15,000 8,500 miles
Low Level of Activity: February 13,600 7,500 miles
Difference $ 1,400 1,000 miles
Step 1:
Variable Cost per Unit = $1,400 ÷ 1,000 miles
= $1.40 variable cost per mile
Chapter Review - Brief Exercise 5-4

High Level of Activity: March $15,000 8,500 miles


Low Level of Activity: February 13,600 7,500 miles
Difference $ 1,400 1,000 miles

Step 1:
Variable Cost per Unit = $1,400 ÷ 1,000 miles
= $1.40 variable cost per mile
Step 2: High Low
Total Cost: $15,000 $13,600
Variable Cost:
8,500 × $1.40 11,900
7,500 × $1.40 10,500
Total Fixed Costs $ 3,100 $ 3,100
Questions

You might also like

pFad - Phonifier reborn

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.

Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.


Alternative Proxies:

Alternative Proxy

pFad Proxy

pFad v3 Proxy

pFad v4 Proxy