AF5231 Managerial Accounting & Information Systems

Cost-Volume-Profit Analysis

AGENDA
The Contribution Margin Concept CVP Analysis and Breakeven Point Margin of Safety and Operating Leverage Sales Mix & CVP Analysis Assumptions of CVP

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The Contribution Margin Concept

The Contribution Margin Concept

For each additional unit Wind sells, $200 more in contribution margin will help to cover fixed expenses and profit.

Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted.
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The Contribution Margin Concept

Each month Wind must generate at least $80,000 in total CM to break even.

The Contribution Margin Concept

If Wind sells 400 units in a month, it will be operating at the break-even point.

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Contribution Margin Ratio

The formula for contribution margin is: Contribution Margin = Sales Variable Cost An alternative to express contribution margin is the contribution margin ratio:
CM Ratio = Total CM = Unit CM Total sales Unit sales
OR

Significance of Contribution Margin

Contribution Margin = Selling Price Variable Cost Represents the amount of revenue left over to recover fixed costs. It indicates how operating incomes changes as the number of units sold changes.

For Wind Bicycle Co. the ratio is:

$ 80,000 $200,000 = 40% $200 = 40% $500

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Objective of CVP Analysis

Examines the behavior of total revenue, total costs and operating income with:

CVP Analysis Approaches

Formula Approach
GeneralFormula ContributionMarginFormula

inOutputLevel inSellingPrice inVariableCost/Unit inFixedCosts

Graphical Approach

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Equation Method
Profits = Sales (Variable expenses + Fixed expenses) OR Sales = Variable expenses + Fixed expenses + Profits

Break-Even Analysis
Here is the information from Wind Bicycle Co.:

At the break-even point profits equal zero.

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Equation Method
We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits

Equation Method
We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $0

Where: Q = Number of bikes sold $500 = Unit selling price $300 = Unit variable expense $80,000 = Total fixed expense

$500Q = $300Q + $80,000 + $0 $200Q = $80,000 Q = $80,000 $200 per bike Q = 400 bikes

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Equation Method
We can also use the following equation to compute the break-even point in sales dollars.
Sales = Variable expenses + Fixed expenses + Profits

Equation Method
We can also use the following equation to compute the break-even point in sales dollars.
Sales = Variable expenses + Fixed expenses + Profits

X = 0.60X + $80,000 + $0
Where: X = Total sales dollars 0.60 = Variable expenses as a % of sales $80,000 = Total fixed expenses

X = 0.60X + $80,000 + $0 0.40X = $80,000 X = $80,000 0.40 X = $200,000

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Contribution Margin Method

The contribution margin method is a variation of the equation method.
Break-even point = in units sold Fixed expenses Unit contribution margin

CVP Relationships in Graphic Form

Viewing CVP relationships in a graph is often helpful. Consider the following information for Wind Co.:

Break-even point in total sales dollars =

Fixed expenses CM ratio

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CVP Graph
Total Sales Total Expenses Fixed expenses

CVP Graph

Break-even point

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Income Tax Consideration

The profit considered previously ignore income tax consideration The equation to convert Pretax profit to after tax profit is:
After-tax Profit = Pretax Profit x (1 - tax rate)

Margin of Safety (MOS)

Excess of estimated (or actual) sales over the break-even volume of sales. Indicates the amount by which sales can drop before losses begin to be incurred.
MOS (Sales) = Actual/Estimated Sales - BE (Sales) MOS (Qty) = Actual /Estimated Qty - BE (Qty)
MOS % = MOS (Sales) Act./Est. Sales
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MOS (Qty) Act./Est. Qty

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Wind has a break-even point of $200,000. If actual sales are $250,000.

Example Margin of Safety

The Margin of Safety

The margin of safety can be expressed as 20% of sales. ($50,000 $250,000)

The margin of safety = $50,000 ($250,000 - $200,000) or 100 bikes ($50,000/500).

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Degree of Operating Leverage

Measures the extent to which the cost function is comprised of fixed costs. Indicates the sensitivity of profit change to sales change
A high operating leverage is indicative of high committed costs (e.g. interest). A relatively small change in sales can lead to a loss.
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Degree of Operating Leverage

3 ways to compute degree of operating leverage:

degree of
A low operating leverage is indicative of low committed costs (e.g. interest). More of the costs are variable in nature.

operating leverage

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Example: Operating Leverage

Operating Leverage
With a operating leverage of 5, if Wind increases its sales by 10%, net operating income would increase by 50%.

$100,000 = 5 $20,000
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Multiproduct C-V-P Analysis

Assumes a constant product sales mix Find Contribution Margin of each individual product Contribution margin is weighted on the quantities of each product included in the bag of products

Multiproduct C-V-P Analysis

Step 1 Determine CM/unit for each product & fixed cost

Sales mix Contribution margin per unit FC = $8,000

3 $2

2 $1

The Bag Three units of spray for every two units of liquid
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Multiproduct C-V-P Analysis

Step 2 Apply breakeven equation.

Multiproduct C-V-P Analysis

Step 3 Breakeven Units = Bag x Sales Mix

Sales mix Contribution margin per unit

3 $2

2 $1 Breakeven

Sales mix

$8000 3($2) + 2($1) = 1,000 bags

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x 1,000 2,000 To breakeven, sell 3,000 sprays and 2,000 liquids

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Breakeven bag x 1,000 3,000 Breakeven units

Quantity of output units

Assumptions of CVP Analysis

=ONLYrevenuedriverandcostdriver

Concept Check
Coffee Klatch is an espresso kiosk. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the CM Ratio for Coffee Klatch? a.1.319 b.0.758 c.0.242 d.4.139
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Total cost can be separated into fixed and variable costs Total revenue and costs are linear within the relevant range Single product or constant sales mix Unit selling price, unit variable costs, and fixed costs are known and constant Time value of money ignored
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Concept Check
Coffee Klatch is an espresso kiosk. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. How many cups of coffee would have to be sold to attain target profits of $2,500 per month? a.3,363cups b.2,212cups c.1,150cups d.4,200cups
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Concept Check
Coffee Klatch is an espresso kiosk. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the margin of safety? a.3,250cups b.950cups c.1,150cups d.2,100cups
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Concept Check
At Coffee Klatch the average selling price of a cup of coffee is $1.49, the average variable expense per cup is $0.36, and the average fixed expense per month is $1,300. 2,100 cups are sold each month on average. If sales increase by 20%, by how much should net operating income increase? a.30.0% b.20.0% c.22.1% d.44.2%
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