Chapter 5: Cost-Profit-Volume Analysis
Operating Leverage
Is the degree to which a company's net income reacts to a change in sales; provides a measure of the company's earnings volatility.
Cost Structure
Is the relative proportion of fixed versus variable costs that a company incurs--cost structure can have a significant effect on company profitability.
Breakeven Point
The level of sales where the company will realize no income and will suffer no loss; (where Revenues=Expenses and Profit=0).
Companies with high fixed costs relative to variable costs have...
high operating leverage. (high earnings volatility)
When a company's sales revenue is increasing, high operating leverage is good because it means that profits will _____. However, when sales are declining, too much operating leverage will cause profit to _____.
increase rapidly; decrease rapidly
Cost-Volume-Profit (CVP) Analysis
The study of the effects of changes in costs and volume on company's profits ("What-If Analysis"). -it is an important profit planning tool (short-range) -It is also useful in setting selling prices, determining product mix, and maximizing use of production facilities.
Target Net Income
The profit objective for the company or an individual segment. Example: -$100,000 next year -10% of Sales OR -a 5% increase over last year
Sales Mix
The relative proportion in which each product is sold (when a company sells more than one product). Example: Product A: 1000 units Product B: 4000 units 5000 total units 1000/5000= 20% for A 4000/5000=80% for B
The degree of operating leverage can be used to...
determine the effect changes in sales will have on NI. Percentage change in Net Operating Income= Degree of Operating Leverage x % Change in Sales
To determine required sales for EACH PRODUCT, ...
multiply by percentage of sales contributed from each product. Sales Mix x Overall Breakeven= Sales $ required from a product line
Operating leverage is determined by...
relative use of fixed vs. variable costs. Degree of Operating Leverage= Total Contribution Margin/Net Income
The choice of cost structure must be carefully considered by companies since...
there are many ways that they can influence their cost structure.
CVP Analysis Equations
1. Equation Method 2. Contribution Margin (Formula) Method 3. Contribution Margin Ratio Approach
ASSUMPTIONS underlying CVP analysis
-Costs and revenues are linear throughout the relevant range. SP + VP per unit are constant; Total FC is constant. -Costs can be classified as either variable or fixed with reasonable accuracy. (high-low method) -All units produced are sold. -Sales mix will remain constant.
Variable Cost Ratio
1. Variable Cost Ratio= Total Variable Cost divided by Total Sales $ 2. Variable Cost Ratio= Variable Cost/unit divided by Sales Price/unit
For CVP Analysis for two or more products, must consider sales mix in CVP calculations:
Break-even in sales dollars for a multiple-product firm is calculated as: Sales $= (Total Fixed Costs+Desired Profit)/(Overall CM Ratio)
Equation Method
Revenues-Variable Costs-Fixed Costs= Desired Profit Let SP= Sales Price and X= Sales Volume SP(X)-(VC/unit)(X)-FC= Desired Profit
Traditional Income Statement Format
Sales -COGS (product) =Gross Margin -Operating Expenses (period) =Income
Contribution Margin Income Statement Format
Sales Less: Variable Costs (product + period) Contribution Margin Less: Fixed Costs (product + period) Income
Contribution Margin Ratio Approach
Sales $= (Total FC+Desired Income Before Tax)/(Contribution Margin Ratio) -Provides answer in SALES DOLLARS -Use if Sales Price and/or VC PER UNIT are not available
Why is Sales Mix important to managers?
Some products are more profitable than others (different SP + VC).
Contribution Margin Income Statement
The Contribution Margin income statement classifies costs as variable or fixed and computes a contribution margin.
Contribution Margin
The amount of sales remaining after variable expenses have been deducted; the amount that remains to cover fixed costs and generate a profit. (i.e., sales that can go toward covering Fixed Costs and Income). Revenues-Variable Costs= Contribution Margin
Sensitivity Analysis
The analysis of the effect of a change in a variable on profit ("What-if Analysis").
Margin of Safety
The difference between actual or expected sales and breakeven sales. Can be expressed in Units, Sales $, or %. Margin of Safety (in sales $)= Expected Sales-Breakeven Sales Margin of Safety %= Margin of Safety/Expected Sales
The Cost-Volume-Profit Graph
The graph allow management to see what profit will be at various levels of sales. -Breakeven point is where the Total Revenue and Costs lines intersect.
Contribution Margin (Formula) Method
X= (Total FC + Desired Income Before Tax)/(Contribution Margin per unit) -Gives sales in UNITS
Contribution Margin can be stated as..
a total amount, a per unit amount or a ratio. 1. Total Contribution Margin= Total Sales-Total Variable Costs 2. Contribution Margin per Unit= Unit Selling Price-Unit Variable Costs 3. Contribution Margin Ratio= Contribution Margin/unit divided by Sales Price/unit or Total Contribution Margin divided by Total Sales $
CVP analysis considers the inherent interrelationships among the following:
a. Volume or level of activity b. Unit selling prices c. Variable cost per unit d. Total fixed costs e. Sales mix -Sales $ and Total VC increase by the same %; Income changes but NOT by the same %; Total FC remains the same.