Session 4: Cost-Volume-Profit Analysis

Question 1

What is Cost-Volume-Profit Analysis?

Answer 1

Cost-volume-profit (CVP) analysis is a method of cost accounting that looks at the impact that varying levels of costs and volume have on operating profit. The cost-volume-profit analysis, also commonly known as break-even analysis, looks to determine the break-even point for different sales volumes and cost structures, which can be useful for managers making short-term economic decisions.

The cost-volume-profit analysis makes several assumptions, including that the sales price, fixed costs, and variable cost per unit are constant. Running this analysis involves using several equations for price, cost and other variables, then plotting them out on an economic graph.

Question 2

What is the formula for CVP?

Answer 2

The CVP formula can be used to calculate the sales volume needed to cover costs and break even, in the CVP breakeven sales volume formula, as follows:
​	  
Breakeven Sales Volume = 
FC / CM
​	 
where:
FC=Fixed costs
CM=Contribution margin=Sales−Variable Costs

To use the above formula to find a company’s target sales volume, simply add a target profit amount per unit to the fixed-cost component of the formula. This allows you to solve for the target volume based on the assumptions used in the model.

Question 3

What Does Cost-Volume-Profit Analysis Tell You?

Answer 3

The contribution margin is used in the determination of the break-even point of sales. By dividing the total fixed costs by the contribution margin ratio, the break-even point of sales in terms of total dollars may be calculated. For example, a company with $100,000 of fixed costs and a contribution margin of 40% must earn revenue of $250,000 to break even.

Profit may be added to the fixed costs to perform CVP analysis on a desired outcome. For example, if the previous company desired an accounting profit of $50,000, the total sales revenue is found by dividing $150,000 (the sum of fixed costs and desired profit) by the contribution margin of 40%. This example yields a required sales revenue of $375,000.

CVP analysis is only reliable if costs are fixed within a specified production level. All units produced are assumed to be sold, and all fixed costs must be stable in a CVP analysis. Another assumption is all changes in expenses occur because of changes in activity level. Semi-variable expenses must be split between expense classifications using the high-low method, scatter plot or statistical regression.

KEY TAKEAWAYS
Cost-volume-price analysis is a way to find out how changes in variable and fixed costs affect a firm’s profit.
Companies can use the formula result to see how many units they need to sell to break even (cover all costs) or reach a certain minimum profit margin.

Question 4

What is the Contribution Margin and the Contribution Margin Ratio?

Answer 4

CVP analysis also manages product contribution margin. Contribution margin is the difference between total sales and total variable costs. For a business to be profitable, the contribution margin must exceed total fixed costs. The contribution margin may also be calculated per unit. The unit contribution margin is simply the remainder after the unit variable cost is subtracted from the unit sales price. The contribution margin ratio is determined by dividing the contribution margin by total sales.

Question 5

What is the formula for Breakeven Point (B/E)?

Answer 5

B/E is when profit = 0

i. e. Contribution p.u x Quantity = Fixed costs
i. e. B/E Quantity = Fixed costs / by Contribution p.u

Question 6

What is the B/E Point?

Answer 6

In accounting, the break-even point formula is determined by dividing the total fixed costs associated with production by the revenue per individual unit minus the variable costs per unit. In this case, fixed costs refer to those which do not change depending upon the number of units sold. Put differently, the breakeven point is the production level at which total revenues for a product equal total expenses.

Question 7

What is the formula for Margin of Safety?

Answer 7

• A measure of how much sales could drop before loss incurred
• i.e. [Budgeted sales (units) minus B/E sales (units) ] divided by Budget sales (units)

Question 8

What is the Margin of Safety?

Answer 8

The margin of safety, or safety margin, refers to the difference between actual sales and break-even sales. Managers can utilise the margin of safety to know how much sales can decrease before the company or a project becomes unprofitable.

KEY TAKEAWAYS
A margin of safety is a built-in cushion allowing for some losses to be incurred without major negative effect,

In accounting the safety margin is built into break-even forecasts to allow for some leeway in those estimates

Question 9

What is the Target Profit?

Answer 9

A profit target is a predetermined point at which an investor will exit a trade in a profitable position. Profit targets are part of many trading strategies that investors and technical traders use to manage risk.

KEY TAKEAWAYS
Profit targets can help an investor reduce risk by creating a target price where the trader wants to take a profit on a trade.
Profit targets can be set up at the onset of a new trade and help a trader reduce portfolio volatility.

Question 10

What is the Contribution Margin?

Answer 10

The contribution margin can be stated on a gross or per-unit basis. It represents the incremental money generated for each product/unit sold after deducting the variable portion of the firm’s costs.

The contribution margin is computed as the selling price per unit, minus the variable cost per unit. Also known as dollar contribution per unit, the measure indicates how a particular product contributes to the overall profit of the company. It provides one way to show the profit potential of a particular product offered by a company and shows the portion of sales that helps to cover the company’s fixed costs. Any remaining revenue left after covering fixed costs is the profit generated.

Question 11

What is the formula for Contribution Margin and for Contribution Margin Ratio?

Answer 11

The contribution margin is computed as the difference between the sale price of a product and the variable costs associated with its production and sales process.

Contribution Margin = Sales Revenue - Variable Costs

The above formula is also used as a ratio, to arrive at an answer in percentage terms, as follows:

Contribution Margin Ratio = [Sales Revenue - Variable Costs]/Sales Revenue
​

Question 12

What does the Contribution Margin tell you?

Answer 12

The contribution margin is the foundation for break-even analysis used in the overall cost and sales price planning for products. The contribution margin helps to separate out the fixed cost and profit components coming from product sales and can be used to determine the selling price range of a product, the profit levels that can be expected from the sales, and structure sales commissions paid to sales team members, distributors or commission agents.

KEY TAKEAWAYS
The contribution margin represents the portion of a product’s sales revenue that isn’t used up by variable costs, and so contributes to covering the company’s fixed costs.
The concept of contribution margin is one of the fundamental keys in break-even analysis.
Low contribution margins are present in labor-intensive companies with few fixed expenses, while capital-intensive, industrial companies have higher fixed costs and thus, higher contribution margins.

Question 13

How can CVP Analysis be used for ‘What If…’ Questions?

Answer 13

• Extra sales volume required if we are to cover
additional fixed costs?
• Number of units needed to be sold if we are to make a
required profit?
• Selling price need to charge if we want to make a
required profit?
• Effect on profits if selling price is reduced and more
units sold?
• Simply use the formula,
Profit = [(SP - VC) x Quantity] - FC
let x = one unknown variable, and solve formula for x

Question 14

How is CVP Analysis used when there are multiple products involved?

Answer 14

Calculate Contribution Margin (CM) from combined
products P&L with given sales mix, then either:
• weighted average CM per unit (-> B/E in units) - if units sufficiently similar to sensibly aggregate & express B/E in units, OR
• CM Ratio (or %) = Total Combined P&L Contribution /
Total Combined P&L Sales
Represents incremental profit from an extra € of sales e.g.
-> B/E Sales in € = Total Fixed Costs / CM Ratio

• Some fixed costs likely relate directly to particular
products (and therefore ‘avoidable’ if product ceased)
• Whilst others fixed costs are indirect/shared/common
• Segment margin/product line profit is a product’s
contribution after direct fixed costs (JJ: 4-20; 7-10 to 12)
– use to evaluate if a product line is profitable
• Never allocate indirect fixed costs to evaluate if a
product is profitable -> cost allocation death spiral!

Question 15

What are some assumptions that must be made to do CVP analysis?

Answer 15

• Costs can be split between fixed and variable
– Challenge of ‘mixed costs’ and ‘step costs’
– Use ‘scatter graphs’, ‘high-low method’, ‘regression
analyses’ and/or ‘account analyses’ to split
• Cost/revenue behaviour (FC, VC & SP) stays as
predicted across the activity levels of interest
• In multi-product scenarios, must assume a
constant sales mix

Question 16

What is the Degree of Operational Leverage (DOL)?

Answer 16

The degree of operating leverage (DOL) is a multiple that measures how much the operating income of a company will change in response to a change in sales. Companies with a large proportion of fixed costs to variable costs have higher levels of operating leverage.

The DOL ratio assists analysts in determining the impact of any change in sales on company earnings.

Question 17

What is the formula for Degree of Operational Leverage (DOL)?

Answer 17

DOL = % change in EBIT / % change in sales
OR
DOL = Contribution / Operating Profit
OR
DOL = change in operating income / change in sales
DOL = [sales - variable costs] / [sales - variable costs - fixed costs]
DOL = contribution margin percentage / operating margin

Question 18

What does DOL tell you?

Answer 18

The higher the degree of operating leverage (DOL), the more sensitive a company’s earnings before interest and taxes (EBIT) are to changes in sales, assuming all other variables remain constant. The DOL ratio helps analysts determine what the impact of any change in sales will be on the company’s earnings.

Operating leverage measures a company’s fixed costs as a percentage of its total costs. It is used to evaluate a business’ breakeven point—which is where sales are high enough to pay for all costs and the profit is zero. A company with high operating leverage, has a large proportion of fixed costs—which means that a big increase in sales can lead to outsized changes in profits. A company with low operating leverage has a large proportion of variable costs—which means that it earns a smaller profit on each sale, but does not have to increase sales as much to cover its lower fixed costs.

KEY TAKEAWAYS
The degree of operating leverage (DOL) is a multiple that measures how much the operating income of a company will change in response to a change in sales.
The DOL ratio assists analysts in determining the impact of any change in sales on company earnings.
A company with high operating leverage has a large proportion of fixed costs, which means that a big increase in sales can lead to outsized changes in profits.

Question 19

What are variable costs?

Answer 19

Costs that change in proportion to changes in volume or activity. Thus, if activity increases by 10%, variable costs are assumed to increase by 10%. These may include direct and indirect materials, direct labour, energy and sales commissions.

Question 20

What are fixed costs?

Answer 20

Costs that do not change in response to changes in activity levels. These might include depreciation, supervisory salaries, building maintenance.

Question 21

What is a discretionary fixed cost?

Answer 21

Those that management can easily change in the short run Examples incl. R&D, advertising, repair and maintenance. These are cut when sales drop so that profit trends stay constant. May be shortsighted to do so, however.

Question 22

What is a committed fixed cost?

Answer 22

Those that cannot easily be changed in a relatively brief period of time. These incl. items like rent, depreciation of buildings and equipment, insurance related to buildings and equipment.

Question 23

What are mixed costs (aka semi-variable costs)?

Answer 23

These are costs that are made up of both fixed and variable costs, e.g. a salesperson’s fixed salary + commission. Total production cost is also a mixed cost.

Question 24

What are Step Costs?

Answer 24

Those costs that are fixed for a range of volume but increase to a higher level when the upper bound of the range is exceeded. Example: a supervisor might be able to oversee up to 1500 products produced each week. However, to move to 1501+, a second supervisor needs to be hired and like the first will also need to be paid a full time salary.

Question 25

Is direct labour always a variable cost?

Answer 25

No - in some countries (Japan, Korea) it can be a fixed cost, where labour is not likely to be increased or decreased according to demand. Highly automated companies can also use labour as a fixed cost.

Question 26

What are the three primary cost estimation methods?

Answer 26

• Account analysis: most common, manager’s professional judgement
• Scattergraphs: cost information from several reporting
• High-Low Method: this methods fits a straight line to the data points representing the highest and lowest levels of activity.