managerial accounting chapter 6: Cost-Volume-Profit-Analysis
anything below break even point is considered a ___ because _____
loss because total cost is higher than total revenue anything above is a profit
The difference between the total revenue line and the total cost line
profit, reported as net operating income on the income statement
cost-volume-profit graph, or CVP graph
provides a visual representation of the relationship between total revenue, total costs, volume, and profit. for a CVP graph based on the data in our Starbucks example. The total revenue (blue) line is based on the number of units sold multiplied by the unit sales price ($2.50). A higher unit sales price will result in a steeper total revenue line. The total cost (red) line is the sum of the total fixed and total variable costs. Notice that the total cost line intercepts the y-axis at $12,000. This is the total fixed costs, or the total cost that will be incurred regardless of volume. The variable cost per unit ($1) is represented by the slope of the total cost line, which increases by $1 with each additional unit sold.
Cost structure
refers to how a company uses variable costs versus fixed costs to perform its operations. Some companies have a relatively high proportion of variable costs such as direct materials and direct labor while others have relatively high fixed costs such as facilities, Page 258 equipment, and salaries.
sales mix
sed to compute the weighted-average contribution margin ratio, or contribution margin as a percentage of sales.
break-even analysis
special case of target profit analysis, where the target profit is set equal to zero
margin of safety formula
Actual or Budgeted Sales − Break-Even Sales=Margin of Safety
Weighted-Average Contribution Margin Ratio
Average contribution margin ratio of multiple products weighted according to the percentage of total sales revenue.
Weighted-Average Unit Contribution Margin
Average unit contribution of multiple products weighted according to the percentage of units sold.
confusing paragraph
To illustrate, let's start with a simple but unrealistic scenario in which Starbucks sells only one type and size of coffee. Assume the price is $2.50 per unit and variable costs are $1.00 per unit. Recall from Chapter 5 that variable costs, such as the cost of coffee beans and supplies, increase in direct proportion to the number of units produced or customers served. Fixed costs are $12,000 per month, including rent, insurance, equipment depreciation, salaries, and other costs that must be paid each month regardless of the number of customers served.
we set two profit equations equal to each other so that they yield the same profit. what does this do?
allows us to find the indifference point, or the point at which managers should be indifferent about which alternative to choose because they yield the same profit.
Target profit analysis
an extension of break-even analysis that allows managers to determine the number of units or total sales revenue needed to earn a target profit
The product mix is used to
compute the weighted-average contribution margin per unit
An alternative tool that can be used to answer most cost-volume-profit questions
contribution margin income statement (makes a distinction between variable and fixed costs
Existing companies base the margin of safety on
the most recent period's sales; new businesses base it on budgeted or expected sales. example if you were thinking of opening a new Starbucks location and had developed a business plan based on an anticipated or budgeted sales level, it would be wise to compare that level to the break-even point. Doing so would show you how much cushion you have between making a profit and suffering a loss. Expressing the margin of safety as a percentage of actual or budgeted sales provides a better idea of how large this buffer zone is. To calculate margin of safety as a percentage, divide the margin of safety by the actual or budgeted sales.
break-even point
the point at which the total revenue and total cost lines cross (leaving zero profit)
Break-even analysis is the simplest form of cost-volume-profit analysis. What's the goal of break-even analysis?
to determine the level of sales (in either units or total sales dollars) needed to break even, or earn zero profit. MOST MANAGERS WANT TO DO MORE THAN BREAK EVEN- they want to earn a profit profit equation approach can be easily extended to include a target profit by setting the profit equation equal to an amount other than zero. WITH TARGET PROFIT ANALYSIS
At this point, you may be wondering why you need to know more than one way to solve a CVP problem.
understand the relationships among the various methods and formulas rather than memorizing a single formula or approach to the problem. Doing so will help you on exams when you aren't given all of the information needed to answer the question a certain way. Managers must often deal with missing or incomplete information. Although the unit contribution margin method is very intuitive, the contribution margin ratio method is more practical, particularly as the number of products or services increases.
There are several different approaches or methods we can use to model the relationship between revenues, costs, profit, and volume, including the following:
Profit Equation Method Unit Contribution Margin Method Contribution Margin Ratio Method Each of these methods provides a different way to express the CVP relationships, or a different approach to answering the same basic question. Which method you choose: partly personal preference, but also depends on how the question is asked and what data you have available to answer it. As long as you have complete information, you can use any of these methods and come to the same final answer.
To determine the sales level needed to earn a target profit of at least $10,500, we can use the contribution margin ratio formula introduced earlier in the chapter, as follows:
Total Fixed Costs + Target Profit/Contribution Margin Ratio (%)=Target Sales As we discovered earlier in the chapter, you could get this same number by dividing the total fixed costs plus the target profit by the new unit contribution margin as follows: see formula
what are the two simplest types of cvp analysis?
break-even analysis (How many units or sales dollars do I need to break even, or earn zero profit?) and target profit analysis (How many units or sales dollars do I need to earn a target profit?)
Cost-volume-profit (CVP) analysis
decision-making tool that focuses on the relationship among the volume and mix of units sold, prices, variable costs, fixed costs, and profit
financial leverage
decisions about the use of debt versus equity affect a company's
unit contribution margin
ells us how much each unit sold contributes toward fixed costs and profit This amount is used first to cover total fixed costs, with the remainder as profit. As with the profit equation approach, we can use the unit contribution margin method for both break-even and target profit analysis.
What does the CVP framework allow managers to evaluate?
how changing one or more of these key variables will impact profitability, while holding everything else constant. For example, a Starbucks manager might ask the following questions: How many customers must I serve each month to break even, or earn zero profit? My boss expects the business to earn $18,000 in profit each month. How much total sales revenue is needed to achieve this goal? Economic conditions have had a negative impact on customer demand. How much can sales drop before the business is operating at a loss? I've been thinking about investing in technology that would speed up service to customers. How many additional customers must we serve each day to justify this investment? If I expand our product offering to sell green tea, muffins, and sandwiches, how will it affect the bottom line? can be addressed using cost-volume-profit analysis, but requires us to make key assumptions, if the assumptions dont hold true, out conclusion will be flawed
The key to performing CVP analysis in a multiproduct or service setting is to
make an assumption about the relative mix of products or services sold. The mix can be stated in terms of the number of units sold (called the product mix) or as a percentage of total sales dollars (called the sales mix). Which method you use depends on how the information is presented and whether you are trying to solve for the number of units or total sales revenue. . As with the single-product scenarios, both methods will yield the same answer as long as you have complete information, including unit sales prices. The only caveat is that the analysis will be valid only for the assumed product or sales mix.
what can mangers use CVP to do?
make many different decisions, such as whether to change the price of the product, buy materials from a different supplier, pay employees a salary instead of commission, spend more on advertising, or invest in automated equipment. The CVP model allows managers to perform "what if " analysis to see how changing one or more variables will affect the others. In the next section, we use the CVP framework to analyze several different managerial scenarios Notice that both the unit contribution margin and the contribution margin ratio increase with the increase in sales price. As a result, every unit and dollar of sales will generate more contribution margin and thus profit.
Degree of operating leverage
measures the extent to which fixed costs are used to operate the business. In general, higher fixed costs indicate that a company is more highly leveraged. Degree of operating leverage is calculated as follows: Degree ofOperating Leverage=Contribution Margin/Net Operating Income A degree of operating leverage greater than one means that managers are using fixed costs to at least some degree. Because fixed costs do not change with changes in volume, a degree of operating leverage greater than one means that a given change in sales volume will have an even bigger effect on profit. For example, if a company has a degree of operating leverage of 2, a 10 percent change in sales revenue will result in a 20 percent change in profit. The degree of operating leverage is a multiplier that we can use to predict how a percentage change in sales revenue will translate into a percentage change in profit. I In general, a company with a high degree of operating leverage (high fixed costs) will experience greater swings in profit as a result of changes in sales revenue and is therefore considered riskier than a comparable company with a smaller degree of operating leverage.
Decisions about whether to use fixed or variable costs to run the business affect a company's
operating leverage
Cost-volume-profit analysis is based on the following assumptions
study chart page 247 Assumption Explanation 1. Linear cost and revenue functions We will use a straight line to approximate the relationship between total cost and sales volume, as well as total revenue and sales volume. 2. All costs can be classified as either fixed or variable For mixed costs, we must determine the total fixed cost and variable cost per unit. (Refer to Chapter 5 for a review of the methods used to estimate cost behavior.) We assume step costs will remain fixed within the relevant range. 3. Only volume affects total cost and total revenue We ignore other factors that can affect costs and revenue, such as employee learning curves, productivity gains, and volume discounts for buying in bulk. 4. Production volume is equal to sales volume This simplifies the analysis because some costs vary with production while others vary with sales volume. Holding inventory constant also eliminates any differences in profit that are due to the costing method used to value inventory for external reporting. (See the supplement to Chapter 5 for further discussion of the effect of changing inventory levels on profit.) 5. Constant product mix For companies that sell multiple products and services, we assume that the relative proportion of units sold or sales revenue generated by each product or service line remains constant.
Managers face many decisions that can affect their cost structure and have implications for cost-volume-profit analysis. what is an example of this?
the decision to automate a process that is currently done manually. Automation typically reduces variable costs (by reducing direct labor) while increasing fixed costs (by increasing equipment depreciation, maintenance, and supervision). there is a greater risk with automation in the event that demand is not as large as expected. This risk is reflected in a measure called degree of operating leverage, which is discussed next.
margin of safety
the difference between actual or budgeted sales and the break-even point as a buffer zone that identifies how much sales can drop before the business will suffer a loss most relevant to companies that face a significant risk of not making a profit, such as start-up businesses or companies that face extreme competition or abrupt changes in demand.
contribution margin
the difference between sales revenue and variable costs, or the amount of profit available to cover fixed costs and profit.
Profit equation method
uses an equation in which profit is defined as the difference between total sales revenue and total fixed and variable costs as follows: Total Sales Revenue - Total Variable Costs - Total Fixed Costs = Profit (Unit Price × Q) - (Unit Variable Costs × Q) - Total Fixed Costs = Profit Where: Q = Quantity of units sold Notice that total sales revenue and variable costs are a function of the number of units sold (Q), while total fixed costs are independent of the number of units sold. In CVP analysis, we allow any single factor in the equation to vary while holding everything else constant We can solve for Q to determine the number of units needed to break-even or to earn a target profit. Or if we already know the number of units (Q), we can solve for one of the other unknown variables, such as the sales prices needed to break-even or the maximum fixed costs to earn a target profit.
To find the sales dollars needed to earn a target profit
we simply add the target profit to the total fixed costs in the numerator, and then divide by the contribution margin ratio. For example, the total sales revenue needed to earn $18,000 in target profit would be computed as follows: Total Fixed Costs + Target Profit/Contribution Margin Ratio (%)=Target Sales ($)
To solve for the break-even point in sales revenue
we simply divide total fixed costs of $12,000 by the 60 percent contribution margin ratio, as follows: Total Fixed Costs/Contribution Margin Ratio(%)=Break-Even Sales Notice that this formula is almost identical to the formula for break-even units, except the denominator is the contribution margin ratio rather than the unit contribution margin. The contribution margin ratio allows us to solve for total sales revenue in one step rather than first solving for units and then multiplying by the unit sales price. The end result is the same.