Chapter 8: Cost-Volume-Profit Relationships Flashcards
Cost-volume-profit (CVP) analysis is one of the most powerful tools ____ have
managers
It helps them understand the interrelationships among cost, volume, and profit in an organization
Characteristics of a contribution margin income statement
DIffers from the costing income statement
Ideal tool to explore how profits will change when different operating decisions are made
Preparing a contribution margin income statement
Step 1: Calculate the product cost for each speaker
Step 2: Compute the variable cost of goods sold
Step 3: Compute the variable selling and administrative expense
Step 4: Determine the total fixed cost
STep 5: Putting it all together
Step 1: Calculate the product cost for each speaker
Product cost must only include the variable cost of manufacturing (Direct materials, Direct labour, variable manufacturing overhead)
DOES NOT INCLUDE: Selling or administrative cost
Step 2: Compute the variable cost of goods sold
Start by computing ending inventory
beg. inv) + (Production) - (Quantity Sold) = (Ending inv
When the variable cost per unit is unchanged between periods or there are no inventories, then the variable cost of goods sold can be calculated directly as:
(Variable COGS) = (Variable product cost per unit) x (Units sold)
Step 3: Compute the variable selling and administrative expense
Example from text: The variable selling and admin cost per speaker sold is $30.
The total cost for 400 speakers would be $30 x 400 = $12,000
Step 4: Determine the total fixed cost
The total manufacturing fixed cost (FMOH) and the fixed selling and general and administrative cost (FSG&A) is:
FMOH + FSG&A = $25000 + $10000 = $35000
cost–volume–profit analysis (Look at CVP analysis)
A tool that helps managers understand the interrelationships between cost, volume, and profit.
CVP analysis
Short-form for cost–volume–profit analysis, a tool that helps managers understand the interrelationships between cost, volume, and profit.
contribution margin
The amount available to cover fixed expenses and then provide profits for the period.
Difference between sales revenue and variable expenses
Unit contribution margin
Expressed on a per-unit basis
Contribution margin ratio (CM Ratio)
Expressed as a percentage of sales
Contribution margin / sales * 100
Contribution margin is used ______ to cover fixed expenses, and then whatever remains goes towards ______
First
Profits
If the contribution margin is not sufficient to cover the fixed expenses, then what?
A loss occurs for the period
Break-even point (BEP)
break even point
The level of sales at which profit is zero.
Defined as the point where total sales equal total expenses (variable or fixed)
Or
The point where total contribution margin equals total fixed expenses.
Once BEP has been reached, NI will increase by the amount of the unit CM for each additional unit sold
If neither # units nor price/unit are available: BEP$ = FC / CMR
Once the break-even point has been reached,
net income will increase by the amount of the unit contribution margin for each additional unit sold
Example: If 351 speakers are sold, we can assume net income for the month is $100
contribution margin (CM) ratio
The contribution margin as a percentage of total sales.
CM ratio =
equation
Contribution margin / sales
Example: $40,000 / $100,000 = 40%
CM ratio (Single product company) = (equation)
Per unit contribution margin / per unit sales revenue
Example: $100 / $250 = 40%
CM ratio explained
For each dollar increase in sales, total contribution margin will increase by 40 cents (= $1 sales x CM ratio of 40%)
The impact on contribution margin of any given dollar change in total sales can be computed in seconds by simply applying the CM ratio to the dollar change
FOr example: If Auto Blast plans a $30,000 increase in sales during the coming month, management can expect the contribution margin to increase by $12,000
($30,000 increased sales x CM ratio of 40%)
The contribution format income statement can be expressed in equation form as follows
Profit = (Sales - Variable Expenses) - Fixed expenses
When a company has a single product
Sales = Selling price per unit x Quantity sold = P x Q
Variables expenses = Variable expenses per unit x Quantity sold = V x Q
Profit = (P x Q - V x Q) - fixed expenses
CVP graph (aka break-even chart)
A graph that highlights cost–volume–profit relationships over wide ranges of activity
Breakdown of CVP graph
Unit volume is on the horizontal 9X) axis)
Dollars are on the vertical (y) axis
How to draw a CVP graph
1) Draw a line parallel to the volume axis to represent total fixed expenses (in the example FC were $35,000)
2) Choose some volume of sales and plot the point representing total expenses (fixed and variable) at the activity level you have selected (in example, Robert chose a volume of 600 speakers)
After the point has been plotted, draw a line through it back to the point where the fixed expenses line intersects the dollar axis
3) Again, choose a volume of sales and plot the point representing total sales dollars at the activity level you have selected (example: Robert chose a volume of 600 speakers, sales at that level is 150,000. Draw a line through this point back to the origin
Break even on a CVP graph
When the two lines cross on the graph
Assumptions of CVP analysis
1) Selling price is constant - the price of product / service will not change as volume changes
2) Costs are linear and can be accurately divided into variable and fixed elements
- The variable element is constant per unit
- The fixed element is constant in total over the entire relevant range
3) In multi-product companies, the sales mix is constant
4) In manufacturing companies, inventories do not change - the number of units produces = the number of units sold
Management levers
Unit variable costs
Fixed costs
Selling price
Example 1: Increase in fixed cost, leading to an increase in sales volume
Background: $10,00 increase in advertising will increase sales by 30%, making sales go from $100,000 to $130,000
Lever: fixed cost
incremental analysis
An analytical approach that focuses only on those items of revenue, cost, and volume that will change as a result of a decision.
Example 2: Increase in unit variable costs, leading to an increase in sales volume
Management want to use higher-quality parts, increasing VC from $150 to $160 (lowering contribution by $10 per speaker), they think doing this would increase sales by 20%
Lever: Variable cost
Example 3: Increase in fixed cost, decrease in selling price, leading to an increase in sales volume
Manager wants to cut selling price by $20 per speaker, making a speaker $230 and increase advertising by $15000 per month. Apparently sales will increase by 50% to 600 speakers per month
Levers: Sales price and fixed cost
Example 4: increase in variable cost per unit and decrease in fixed cost, leading to an increase in sales volume
Commission of $15 per speaker rather than salary. THis change will increase monthly sales by 15% to 460 speakers
Lever: Variable cost and fixed cost
Break-even point can be computed using 2 methods
1) Equation method
2) Contribution margin method
Equation method
A method of computing the break-even point that relies on the equation Sales = Variable expenses + Fixed expenses + Profits.
Equation method equation
Sales = Variable expenses + Fixed expenses + Profits
If breaking even profits always = 0!!!!!!!!!
contribution margin method
A method of computing the break-even point in which the fixed expenses are divided by the contribution margin per unit
contribution margin method equation
Break-even point in units sold = Fixed expenses / Unit contribution margin
Variation of CM ratio, this finds the break-even in total sales dollars, rather in units sold
Break-even point in total sales dollars = FIxed expenses / CM ratio
The contribution margin approach
Unit sales to attain target profit = (Fixed expenses + Target profit) / Unit contribution margin
After tax income (ATI) =
equation
(1-t) x before-tax income (BTI)
Before-tax income (BTI) =
ATI / (1-t)
margin of safety
The excess of budgeted (or actual) sales over the break-even volume of sales.
Margin of safety equation =
Total budgeted (or actual) sales - Break-even sales
Margin of safety percentage =
%%%%
Margin of safety in dollars / Total budgeted or actual sales
Cost structure
Refers to a relative proportion of fixed and variable costs in an organization
Lever
A tool for multiplying force.
operating leverage
A measure of how sensitive net income is to a given percentage change in sales. It is computed by dividing the contribution margin by net income.
If operating leverage is high:
A small percentage increase in sales can produce a much larger percentage increase in net income
degree of operating leverage (DOL)
A measure, at a given level of sales, of how a percentage change in sales volume will affect profits. The degree of operating leverage is computed by dividing contribution margin by net income.
degree of operating leverage equation =
Contribution margin / net income
The number from the degree of operating leverage equation says that net income grows x times faster as its sales
A operating leverage of 4 means the net income grows four times as fast as its sales
Fundamental Mathematical Formula:
% Change = (New – Old) / Old
percentage change
Advantages of Variable Costing and the Contribution Approach
Variable costing combined with the contribution approach, creates many advantages for internal reports:
Enabling CVP analysis
Explaining changes in net operating income
Supporting decision making
Net Operating Income from the Contribution Margin (“Variable Costing”) approach will not necessarily equalNet Operating Income from the Gross Margin (“Absorption Costing”) approach
Because … Costs will hit the Income Statement at different times
Absorption Costing:
- all product costs (both fixed and variable) are assigned to products.
- Both the COGM and COGS will consist of both fixed and variable costs of manufacturing
Variable Costing:
- Only manufacturing costs that vary with output are treated as product costs (DM, DL & variable MOH)
- Both the COGM and COGS will consist of only variable costs of manufacturing.
- Fixed manufacturing costs are treated as period costs and expensed during the accounting period
