Week 3 Flashcards
CVP applications:
1) Aids in setting prices for products and services
2) Determining the short term cost/profit implications and decisions
3) Determining the desirability of replacing a fixed asset
4) Determining the BE
5) Determining the best product mix
What is CVP?
Cost-Volume-Profit analysis evaluates how operating and marketing decisions affect short-term profits, analysing the relationships between variable costs, fixed costs, unit selling price and the output level.
Five factors included in the CVP analysis:
Variable cost per unit
Total fixed costs
Sales volume
Selling price
Salex mix (relevant only to multiproduct firms, represents the relative volume of products sold)
CVP equation, Contribution margins:
Pi = (pQ)-(VCQ)-FC
Contribution margin per unit - the difference between selling price and VC per unit. Measures profit increase with each unit.
Total Contribution margin - CM per unit multiplied by sold Q.
Contribution margin ratio - the ratio of the contribution margin per unit to the selling price per unit: (p-VC)/p, projected increase or decrease in OP caused by an increase in sales dollars can be determined.
Example Setup
Given:
Selling Price per Unit: $100
Variable Cost per Unit: $60
Fixed Costs: $40,000
Change in Total Sales Dollars: +$10,000
Step 1: Calculate Contribution Margin per Unit
The contribution margin per unit is the selling price per unit minus the variable cost per unit.
Contribution Margin per Unit
= Selling Price per Unit − Variable Cost per Unit
Contribution Margin per Unit=$100−$60=$40
Step 2: Calculate Contribution Margin Ratio
The contribution margin ratio (CM Ratio) is the contribution margin per unit divided by the selling price per unit, expressed as a percentage.
CM Ratio = (Contribution Margin per Unit Selling Price per Unit) × 100%
Step 3: Calculate Change in Operating Profit
Using the CM Ratio, you can determine the increase in operating profit for the given increase in total sales dollars.
Change in Operating Profit=$10,000×40%=$4,000
Contribution income statement:
Separates fixed and variable costs, in contrast to conventional IS which focuses on product and non-product costs, to emphasize cost behavior. The total contribution margin is calculated by subtracting variable costs from sales, after which fixed costs are also subtracted to get OP.
Changes in OP that result from changes in sales can be accounted for.
CVP BE point in dollars and units formulas:
Q = F/(p-v)
Y=F/((p-v)/p)
Profit planning using CVP:
Same equation as used in BE analysis, however, specific profit target is set (pre-tax).
Cost planning decisions usually assume fixed volume and profit and tries to find required VC or FC to achieve the desired profits
In the case of taxes:
Pi/(1-t), where Pi is the desired after-tax profit.
CVP in activity-based costing:
Using CVP with ABC allows for certain costs treated as fixed in volume-based analysis to be recognized as variable. While product, batch and facility level costs are treated as fixed in the volume-based, ABC demonstrates that batch costs can vary with sales in the short-term.
New formula:
Q = (F+Pi)/(p-v-(Vab/b))
If we get a fractional number, we must round it up and calculate the new BE, to get the desired profit.
Dealing with risk and uncertainty:
Uncertainty: refers to the degree to which many values can exist for one or more of the variables
Risk: refers to the possibility of loss or gain due to this uncertainty
Sensitivity analysis: includes a variety of methods of how an amount (e.g. operating profit) changes if factors involved change.
What-if-analysis: calculation of an amount given different levels of a factor that influences this amount.
Decision tree and table: form of analysis that estimates a probability for each possible event, and demonstrates the set of possible successive actions or decisions that could take place. Expected value can be estimated.
Margin of safety (MOS):
the planned or actual sales above the breakeven point. For instance, a firm sold 3000 units, BE is 1500, MOS then is 1500 units.
Sales dollars: MOS*Price.
MOS ratio is a useful measure for comparing the risk of two or more alternative products (or decision variables). Expressed as a percentage of sales:
(Planned sales-BE)/Planned sales
Sales volume can decrease by MOS ratio percent before losses start occurring.
Operating leverage:
Refers to the extent of fixed costs in an organisation’s structure.
The higher the amount of fixed costs, the higher the operating leverage, therefore the greater the sensitivity of operating income to changes in sales volume
Degree of operating leverage (DOL):
is a measure of sensitivity of operating income to changes in sales volume.
DOL = Contribution margin/Operating profit
If DOL = 3, this means 1% increase in sales will lead to 3% increase in operating profit.
CVP analysis with two or more products:
1) Weighted average contribution margin per unit, determined based on the contribution margin per unit for a product weighted by the sales mix percentage.
2) Weighted average contribution margin ratio: determined based on the contribution margin ratios of the individual products weighted by sales mix.
3) Sales basket approach: we create a basket that consists of units of the products. Then we calculate the weighted average contribution margin per unit or ratio.
First determine the amount of baskets needed to acquire the desired profit
Second, convert to needed individual units based on the basket size
Limitation of CVP:
The CVP assumes that revenues and costs are linear over relevant range
Another consideration is step costs, which make calculations burdensome.
