Chapter 3 Cost Volume Analysis

Cost-Volume-Profit Equation

(Selling Price*Quantity of Units Sold) -(Unit Variable Costs*Quantity of Units Sold) -Fixed Costs= Operating Income Keep in mind the following: Selling Price * Quantity of Units Sold = Revenue Unit Variable Costs * Quantity of Units Sold = Variable Costs Revenue - Variable Costs = Contribution Margin Contribution Margin - Fixed Costs = Operating Income

Margin of Safety

-An indicator of risk, the margin of safety (MOS), measures the distance between budgeted sales and breakeven sales: -MOS = Budgeted Sales - BE Sales -The MOS ratio removes the firm's size from the output, and expresses itself in the form of a percentage: -MOS Ratio = MOS ÷ Budgeted Sales

CVP for SERVICE and Not-For-Profit organizations

-CVP isn't just for merchandising and manufacturing companies. -Service and Not-for-Profit businesses need to focus on measuring their output which is different from the units sold that we've been dealing with. -For example, a service agency might measure how many persons they assist or an airline might measure how many passenger miles they fly.

COST STRUCTURE

-Managers make strategic decisions that affect the cost structure of the company. -The cost structure is simply the relationship of fixed costs and variable costs to total costs. -We can use CVP-based sensitivity analysis to highlight the risks and returns as fixed costs are substituted for variable costs in a company's cost structure. -The risk-return trade-off across alternative cost structures can be measured as operating leverage.

USING OPERATING LEVERAGE TO ESTIMATE CHANGES IN OPERATING INCOME

-The formula to estimate the change in operating income that will result from a percentage change in sales is: -Operating Leverage X % Change in Sales If sales increase 50% and operating leverage is 1.67, you should expect operating income to increase 83.5%.

Effects of Sales Mix on CVP

-The formulae presented to this point have assumed a single product is produced and sold. -A more realistic scenario involves multiple products sold, in different volumes, with different costs and different margins. -In this case, we use the same formulae, but use average contribution margins for the multiple products. -This technique assumes a constant mix at different levels of total unit sales.

A Five-Step Decision-Making Process in Planning and Control - Revisited

1.Identify the problem and uncertainties. 2.Obtain information. 3.Make predictions about the future. 4.Make decisions by choosing between alternatives, using cost-volume-profit (CVP) analysis. 5. Implement the decision, evaluate performance, and learn.

Sensitivity Analysis

>CVP provides structure to answer a variety of "what-if" scenarios. >"What" happens to profit "if": -Selling price changes. -Volume changes. -Cost structure changes. >Variable cost per unit changes. >Fixed costs change. As an example, if a company determines that an ad campaign costing $15,000 is expected to increase sales 25%, should they proceed? That question cannot be properly answered without doing this type of analysis.

Foundational Assumptions USED in CVP ANALYSIS

>Changes in production/sales volume are the sole cause for cost and revenue changes. >Total costs consist of fixed costs and variable costs. >Revenue and costs behave and can be graphed as a linear function (a straight line). >Selling price, variable cost per unit, and fixed costs are all known and constant. >In many cases only a single product will be analyzed. If multiple products are studied, their relative sales proportions are known and constant. >The time value of money (interest) is ignored.

What is CVP? How is it used?

>Managers want to know how profits will change as the units sold of a product or service changes. >Managers like to use "what-if" analysis to examine the possible outcomes of different decisions so they can make the best one. >In Chapter 2, we discussed total revenues, total costs and income. In this chapter, we take a closer look at the relationship among the elements (selling price, variable costs, fixed costs).

CVP: Contribution Margin

>Manipulation of the basic equations yields an extremely important and powerful tool extensively used in cost accounting: contribution margin (CM). >Contribution margin equals revenue less variable costs. >Contribution margin per unit equals unit selling price less unit variable costs or can be obtained by taking contribution margin divided by number of units sold.

Margin of Safety-Defined

>The margin of safety calculation answers a very important question: >If budgeted revenues are above the breakeven point, how far can they fall before the breakeven point is reached. In other words, how far can they fall before the company will begin to lose money.

Breakeven Point

At the breakeven point, a firm has no profit or loss at the given sales level. Breakeven is where: Sales - Variable Costs - Fixed Costs = 0 Calculation of breakeven number of units Breakeven Units = Fixed Costs/Contribution Margin Per Unit _ Calculation of breakeven revenues Breakeven Revenue = Fixed Costs /Contribution Margin % _

Let's review: emma

Emma has fixed costs of $2,000 and a contribution margin percentage of 40%. If Emma wants to make a profit of $2,000, what must revenue equal? What if Emma wants to make a profit of $3,000, what must revenue equal? Remember the formula: (Fixed Cost+ Target Operating Income) / Contribution Margin % Let's look at the details:

EMMA's ANALYSIS FOR TARGET OPERATING INCOME

For OPERATING INCOME of $2,000 Revenue=(FC+TOI)/CM% Revenue = (2,000+2,000)/.40 =10,000 For OPERATING INCOME of $3,000 Revenue=(FC+TOI)/CM% Revenue = (2,000+3,000)/.40 =12,500

Operating Leverage

Operating leverage (OL) describes the effect that fixed costs have on changes in operating income as changes occur in units sold and contribution margin. OL = Contribution Margin/ Operating Income Notice that the difference between the numerator and the denominator in our formula = our fixed costs.

Breakeven Point, extended: Profit Planning

The breakeven point formula can be modified to become a profit planning tool by adding Target Operating Income to fixed costs in the numerator. Quantity of Units = (Fixed Costs+Target Operating Income)/ Required to Be Sold Contribution Margin per Unit

CVP: Contribution Margin Additional calculations

You can also calculate: -Contribution margin which is equal to the contribution margin per unit multiplied by the number of units sold. -Contribution margin percentage which is the contribution margin per unit divided by unit selling price or -Contribution margin divided by revenue.