Cost Volume Profit Analysis

Cost Volume Profit Analysis
Chapter 16
Chapter Overview
Contribution
Margin Income
Statement and
the Break-Even
Formula
Sales Mix
Graphical
Representation
of Break-Even

Margin of
Safety

Operating
Leverage
Break-even defined
Derivation of the
break-even formula
Break-even point
Effect of changes
in the break-even
formula variables
Target profit
After tax profit
targets

Profit volume
graph
Cost volume profit
graph
Assumptions of
cost volume profit
analysis

Effect on earnings
volatility
2
Chapter Overview
Cost Structures
Today
3
Chapter Overview
Contribution
Margin Income
Statement and
the Break-Even
Formula
Sales Mix
Graphical
Representation
of Break-Even

Margin of
Safety

Operating
Leverage
Break-even defined
Derivation of the
break-even formula
Break-even point
Effect of changes
in the break-even
formula variables
Target profit
After tax profit
targets

Profit volume
graph
Cost volume profit
graph
Assumptions of
cost volume profit
analysis
Effect on earnings
volatility
4
Break-Even Defined
At break-even: total revenue = total costs.

The contribution margin income statement can be used to
derive the break-even formula.

5
Revenues Costs
=
Break-even
Break-Even Defined
At break-even: total revenue = total costs.

The contribution margin income statement can be used to
derive the break-even formula.

6
Revenues Costs
=
Break-even
7
Sales
Variable Costs
= Contribution margin

= Net income
Manufacturing
Selling
Administrative
Manufacturing
Selling
Administrative
VARIABLE COSTING
(CONTRIBUTION MARGIN)
INCOME STATEMENT
Fixed Costs
SP x Q
VC x Q

= Net income
Manufacturing
Selling
Administrative
Manufacturing
Selling
Administrative
VARIABLE COSTING
INCOME STATEMENT
FC
Derivation of the Break-Even Formula
8
Sales
Variable Costs

= Net income
Manufacturing
Selling
Administrative
Manufacturing
Selling
Administrative
VARIABLE COSTING
INCOME STATEMENT
Fixed Costs
SP x Q
VC x Q

= Net income
Manufacturing
Selling
Administrative
Manufacturing
Selling
Administrative
VARIABLE COSTING
INCOME STATEMENT
FC
9
The contribution margin income statement written as an
algebraic equation is as follows:
(SP x Q) (VC x Q) FC = NI
At break-even net income is zero:
(SP x Q) (VC x Q) FC = 0
Add fixed costs to both sides of the equation
(SP x Q) (VC x Q) = FC
Factor out quantity:
Q(SP VC) = FC
Divided both sides of the equation by (SP VC):
Q = =

FC
SP VC
FC
CM
10
Contribution Margin Ratio
Contribution margin ratio percentage of each sales
dollar available to cover fixed costs and provide
income from operations.
Measures the effect of an increase/decrease in sales
volume on income from operations:
Sales Variable Costs
Sales
Contribution Margin Ratio =
11
Break-Even Point
Blazin-Boards Company
Cost Data
Sales Price/Unit $ 400
Variable Costs:
Direct materials $ 80
Direct labor 125
Variable overhead 15
Variable selling expenses 20 240
Fixed Costs:
Factory overhead $800,000
Selling & administrative expense 400,000 $1,200,000

12
Break-Even Point
Income Statement
Sales (7,500 x $400) $3,000,000 100%
Less: Variable expenses (7,500 x $240) 1,800,000 60
Contribution margin $1,200,000 40%
Less: Fixed expenses 1,200,000
Operating income $ 0

Cost Data
Variable Costs:
Direct labor 125
Fixed Costs:

13
Break-Even Point in Units
$1,200,000
$400 $240
Break-Even Sales (Units) =
Fixed Costs
UCM
Break-Even Sales (Units) = 7,500
Cost Data
Variable Costs:
Direct labor 125
Fixed Costs:

14
Break-Even Point in Dollars
Contribution Margin Ratio = 40%
$400 $240
$400
Contribution Margin Ratio =
Break-Even Sales = $3,000,000
$1,200,000
40%
Break Even Sales =
Cost Data
Variable Costs:
Direct labor 125
Fixed Costs:

Income Statement
Sales (7,500 units x $400) $3,000,000
Less: Variable expenses (7,500 x $240) 1,800,000
Contribution margin $1,200,000
Operating income $ 0

Effect of Changes in Break-Even
in the Formula Variables
15
16
Effect of Changes in Fixed Costs
There is a
direct
relationship
between fixed
costs and
break-even
units.
Fixed
Costs
Break
Even
If Then
Fixed
Costs
Break
Even
Then If
17
How would a $200,000
increase in fixed costs affect
the break-even sales units?
18

Before a $200,000 increase in fixed costs:
Unit Contribution Margin = $160
Fixed Costs = $1,200,000
$1,200,000/$160 = 7,500 units needed to break even

After a $200,000 increase in fixed costs:
Unit Contribution Margin = $160

A 1/6 increase in fixed costs equals a 1/6 increase in the unit break-even point.
19
Effect of Changes in Unit Variable Costs
There is a
direct
relationship
between unit
variable costs
and break-
even units.
Unit
Variable
Cost
Break
Even
If Then
Unit
Variable
Cost
Break
Even
Then If
20
How would an extra 2%
commission (increase in
variable cost per unit) affect
the break-even sales units?
21

Before a 2% increase in variable costs
Unit Contribution Margin = 400 240 = $160

After a 2% increase in variable costs
Unit CM = 400 (240 + (400 x .02) = $152

When unit variable cost increases by $8, break-even units increases by 395.
22
Effect of Changes in Unit Selling Price
There is an
inverse
relationship
between unit
selling price
and break-
even units.
Unit
Selling
Price If Then
Break
Even
Break
Even
Unit
Selling
Price
Then If
23
How would a $80 selling price
increase affect the break-even
sales units?
24

Before a $80 selling price increase:
Unit Contribution Margin = 400 240= $160

After a $80 selling price increase:
Unit Contribution Margin = 480 240 = $240

When unit selling price increases by $10, break-even units decreases by 10,000.
25
Target Profit
To find units needed to attain a certain target profit, add
the target profit to the fixed costs in the break-even
formula:

The number of units Blazin-Boards Company must sell to
achieve a target profit of $300,000:
Fixed Costs + Target Profit
Unit Contribution Margin
Target Profit (Units) =
$1,2000,000 + $300,000
$160
Target Profit (Units) =
Target Profit (Units) = 9,375
Net income = Operating income Income taxes
= Operating income (Operating income x Tax rate)
= Operating income (1 Tax rate)
Or
Operating income =
Net income
(1 Tax rate)
After Tax Profit Targets
26
$422,500 = Operating income 0.35(Operating income)
$422,500 = 0.65(Operating income)
$650,000 = Operating income
Blazin-Boards Company wants to earn $422,500 in
net income and its income tax rate is 35 percent.
Units = ($1,200,000 + $650,000)/$160
Units = $1,850,000/$160
Units = 11,563 (rounded)
27
Income Statement
Per
Total Unit
Sales (11,563 x $400) $4,625,200 $400
Less: Variable expenses (11,563 x $240) 2,775,120 240
Contribution margin $1,850,080 $160
Operating income $ 650,080
Less: income taxes ($650,080 x 0.35) 227,528
Net income $ 422,552

How much sales revenue must Blazin-Boards
generate to earn a before-tax profit of $650,080?
Sales = ($1,200,000 + $650,080)/0.40
= $1,850,080/0.40
= $4,625,200
29
Profit Targets
Contribution
Margin
Chapter Overview
Contribution
Margin Income
Statement and
the Break-Even
Formula
Sales Mix
Graphical
Representation
of Break-Even

Margin of
Safety

Operating
Leverage
Break-even defined
Derivation of the
break-even formula
Break-even point
Effect of changes
in the break-even
formula variables
Target profit
After tax profit
target

Profit volume
graph
Cost volume profit
graph
Assumptions of
cost volume profit
analysis
Effect on earnings
volatility
30
Sales Mix
Blazin-Boards Company plans to sell 10,000 regular
snowboards and 2,500 deluxe snowboards in the coming
year.
Product price and cost information includes:

Common fixed selling and administrative expenses total
$200,000.

31
Regular Deluxe
Snowboards Snowboards
Price $ 400 $ 600
Unit variable cost 240 300
Direct fixed cost 400,000 200,000

Sales Mix
Individual products , regular snowboards and deluxe
snowboards , may be thought of as one package product
P.
Unit selling price, unit variable cost, and unit contribution
margin of P equal the unit selling prices, variable costs,
and unit contribution margins of regular snowboards and
deluxe snowboards multiplied by the sales mix ratios:

32
Unit selling price of P ($400 x 4) + ($600 x 1) $2,200
Unit variable cost of P ($240 x 4) + ($300 x 1) 1,260
Unit contribution margin of P $ 940
Contribution margin of P
Sales Mix
The break-even sales of package, P, is calculated by
dividing total fixed costs (direct and common) by the
weighted average contribution margin:
33
Total fixed costs $800,000
Product P contribution margin $940
Break-even sales of individual products:
Regular snowboards (851 x 4) 3,404
Deluxe snowboards (851 x 1) 851
Break-even sales units of P
= 851 units of P
Chapter Overview
Contribution
Margin Income
Statement and
the Break-Even
Formula
Sales Mix
Graphical
Representation
of Break-Even

Margin of
Safety

Operating
Leverage
Break-even defined
Derivation of the
break-even formula
Break-even point
Effect of changes
in the break-even
formula variables
Target profit
After tax profit
target

Profit volume
graph
Cost volume profit
graph
Assumptions of
cost volume profit
analysis
Effect on earnings
volatility
34
35
Profit Volume Graph
Focuses on profits.
Plots the difference between profits and sales volume
Construct a profit-volume chart assuming:
Unit selling price $10
Unit variable cost 5
Unit contribution margin $ 5

Fixed costs $100

Break-even = $100/$5
= 20 units

Maximum loss is $100 in fixed
costs (if no sales). Assume
maximum profit is $100
(based on 40 maximum sales).
Profit Volume Graph
36
Profit
or Loss
$100
80
60
40
20
0
- 20
- 40
-60
-80
-100

5 10 15 20 25 30 35 40 45 50
| | | | | | | | | |
Units Sold
Relevant range
is 50 units.
Profit Volume Graph
37
Profit
or Loss
$100
80
60
40
20
0
- 20
- 40
-60
-80
-100

5 10 15 20 25 30 35 40 45 50
| | | | | | | | | |
Units Sold
Sales (40 units x $10) $400
Variable costs (40 units x $5) 200
Contribution margin $200
Fixed costs 100
Operating profit $100
Maximum profit
within the
relevant range.
Maximum loss is
equal to the total
fixed costs.
Profit Volume Graph
38
Profit
or Loss
$100
80
60
40
20
0
- 20
- 40
-60
-80
-100

5 10 15 20 25 30 35 40 45 50
| | | | | | | | | |
Units Sold
Fixed costs 100
Break-Even Point
(20, $0)
Profit Line
(40, $100)
Profit Volume Graph
39
Profit
or Loss
$100
80
60
40
20
0
- 20
- 40
-60
-80
-100

5 10 15 20 25 30 35 40 45 50
| | | | | | | | | |
Units Sold
Fixed costs 100
Break-Even Point
(20, $0)
Profit Line
Operating
Profit
Focus on units to determine
profit or loss at different
levels of operations. At sales
of 25 units, operating profit
will be $25 (5 units above
the 20 break-even point
times $5).
Operating
Loss
Operating
Profit
Cost Volume Profit Graph
The cost-volume-profit graph depicts the relationships
among cost, volume, and profits

Necessary to graph two separate lines:
1. The total revenue line: revenue = price x units
2. The total cost line: (unit variable cost x units) + Fixed
costs

The vertical axis is measured in dollars and the horizontal
axis is measured in units sold

40
Revenue
Units Sold
$500 --
450 --
400 --
350 --
300 --
250 --
200 --
150 --
100 --
50 --
0 --
5 10 15 20 25 30 35 40 45 50 55 60
| | | | | | | | | | | |
Total Revenue
Total Cost
Loss
Break-Even Point
(20, $200)
Fixed Expenses ($100)
Variable Expenses
($200, or $5 per unit)
41
Cost Volume Profit Graph
Assumptions of Cost Volume Profit Analysis
1. The analysis assumes a linear revenue function and a
linear cost function.
2. The analysis assumes that price, total fixed costs, and
unit variable costs can be accurately identified and
remain constant over the relevant range.
3. The analysis assumes that what is produced is sold.
4. For multiple-product analysis, the sales mix is assumed
to be known.
5. The selling price and costs are assumed to be known
with certainty.

42
It Gets Even Worse:
Sprohges Analysis
SCHEIN UND SEIN
(appearance and reality)
Expenditures for capacity costs are incurred before the
capacity is used.
The matching principle requires the capitalized
expenditures to be matched with future reporting periods
by treating a portion of the capitalized cost as an expense
(depreciation expense).
Depreciation expense does not involve any cash outflow.
Sales revenue and variable costs do involve cash flow.

43
It Gets Even Worse:
Sprohges Analysis
SCHEIN UND SEIN
So, to calculate of the number of units to break even, a
fictitious number in the numerator is divided by net unit
contribution margin which represents cash inflow from
sale minus cash outflow to recover variable costs:

This does not make any sense.
44
Fixed Costs
UCM
It Gets Even Worse:
Sprohges Analysis
SCHEIN UND SEIN
What makes break even analysis even more nonsensical
is that the numerator can be arbitrarily changed:
The matching of capitalized costs with future reporting periods
can be based on different depreciation methods:
straightline
double declining balance
sum of the years digits
After a depreciation method has been selected and used for
some time, it can be changed to another method.

45
It Gets Even Worse:
Sprohges Analysis
SCHEIN UND SEIN
Such information is of limited use because the following
factors, among others, are not known:
Physical life of the asset
Economic life of the asset
Future demand for the product
Future selling prices
Future variable costs

46
It Gets Even Worse:
Sprohges Analysis
SCHEIN UND SEIN
Land is purchased as a site for a factory provides
manufacturing capacity.
The expenditure for land like all capacity expenditures
must be recovered.
Land is not depreciable.
The capitalized expenditures for land are not matched
with future periods of benefit.
So, can the cost of land enter into break even analysis in a
way that makes sense?

47
It Gets Even Worse:
Sprohges Analysis
SCHEIN UND SEIN
Break even analysis can be used to calculate the number
of units needed to recover the initial expenditure for
capacity costs, including the cost of land.
The numerator is the amount of the expenditure to
acquire capacity and the denominator equals contribution
margin:

48
Cost of capacity
UCM
Units needed to recover cost =
It Gets Even Worse:
Sprohges Analysis
SCHEIN UND SEIN
Accumulated depreciation represents the cumulative cost
of capacity of depreciable assets recovered to date.
Book value is the amount of the initial expenditure that
still needs to be recovered.
Textbooks on cost/managerial accounting do not provide
any evidence that firms use break even analysis.

49
It Gets Even Worse:
Sprohges Analysis
SCHEIN UND SEIN
Break even analysis can be used to calculate the number
of units needed to recover the initial expenditure for
capacity costs, including the cost of land.
The numerator is the amount of the expenditure to
acquire capacity and the denominator equals contribution
margin:

50
Cost of capacity
UCM
Units needed to recover cost =
Chapter Overview
Contribution
Margin Income
Statement and
the Break-Even
Formula
Sales Mix
Graphical
Representation
of Break-Even

Margin of
Safety

Operating
Leverage
Break-even defined
Derivation of the
break-even formula
Break-even point
Effect of changes
in the break-even
formula variables
Target profit
After tax target
profit

Profit volume
graph
Cost volume profit
graph
Assumptions of
cost volume profit
analysis
Effect on earnings
volatility
51
52
Margin of Safety
Margin of safety is used to assess risk.

Margin of safety measures how much sales revenue
can drop before an operating loss occurs.

Assume current sales and break even sales in dollars
and units are as follows:

Dollars Units
Sales $400,000 10,000
Break-even sales 300,000 7,500
Excess $100,000 2,500
53
Margin of Safety
A
Dollars Units
Sales $400,000 10,000
Excess $100,000 2,500
Actual sales level.
B
54
Margin of Safety
A
Dollars Units
Sales $400,000 10,000
Excess $100,000 2,500
Excess of actual sales
over the break-even
sales.
Margin of safety
expressed in units.
What is the margin of safety as
a percentage?
55
Margin of Safety
B
Sales Sales at break-even point
Sales
A
Dollars Units
Sales $400,000 10,000
Excess $100,000 2,500
Margin of safety (B/A) 25% 25%
56
Margin of Safety
B
Sales Sales at break-even point
Sales
A
Margin of safety indicates the decrease in
sales that may occur before an operating
loss results.
Dollars Units
Sales $400,000 10,000
Excess $100,000 2,500
Margin of safety (B/A) 25% 25%
Chapter Overview
Contribution
Margin Income
Statement and
the Break-Even
Formula
Sales Mix
Graphical
Representation
of Break-Even

Margin of
Safety

Operating
Leverage
Break-even defined
Derivation of the
break-even formula
Break-even point
Effect of changes
in the break-even
formula variables
Target profit
After tax profit
target

Profit volume
graph
Cost volume profit
graph
Assumptions of
cost volume profit
analysis
Effect on earnings
volatility
57
Operating Leverage
Operating leverage is the use of fixed costs to magnify
the effects of changes in sales on the firms net income:

The degree of operating leverage is a measure of the
relative mix of variable costs and fixed costs.
58
Total contribution margin
Income from operations
Operating Leverage
Companies with high fixed costs
(capital intensive) have high
operating leverage.

Companies with low fixed costs
(labor intensive) have low
Operating leverage.

Operating leverage measures how changes in sales affect
changes in income from operations.
59
$
Total Revenue
Volume
Total Costs
$
Total Revenue
Volume
Total Costs
Break Even
Break Even
Automated System Manual System

Operating Leverage
60
The degree of operating leverage is a
measure of the relative mix of
variable costs and fixed costs.
Contribution margin
Operating income
Sales $1,000,000 $1,000,000

Operating Leverage
61
Contribution margin
Operating income
Sales $1,000,000 $1,000,000
Variable costs 500,000 800,000


Operating Leverage
62
Contribution margin
Operating income
Sales $1,000,000 $1,000,000
Contribution margin $ 500,000 $ 200,000

Operating Leverage
63
Contribution margin
Operating income
Sales $1,000,000 $1,000,000
Less: total fixed expenses 375,000 100,000

A
Operating Leverage
64
Contribution margin
Operating income
Sales $1,000,000 $1,000,000
Operating income $ 125,000 $ 100,000


A
B
Operating Leverage
65
Contribution margin
Operating income
Sales $1,000,000 $1,000,000
Operating leverage (A/B)


A
B
Operating Leverage
66
4 2
Contribution margin
Operating income
Sales $1,000,000 $1,000,000
Operating leverage (A/B)


A
B
High Fixed
Costs
Low Fixed
Costs
Operating Leverage
67
4 2
Contribution margin
Operating income
For each percentage point change
in sales, income from operations
will change by the operating
leverage times that change
68
Time Time
N
e
t

i
n
c
o
m
e

N
e
t

i
n
c
o
m
e

Company A Company B
Earnings volatility determines company risk and, hence,
value.

Which of the following companies is riskier than the
other?

The Effect of Operating Leverage
on Earnings Volatility
69
Variable
Costs
Fixed
Costs
Do companies
with higher levels of
fixed costs experience
more earnings
volatility?
70
71 Now Lets see what happens when the number of units sold increases by 10%.
72
% 5 . 17
40
40 47
The percentage increased in income is greatest in the All Fixed Company.

% 25
40
40 50
% 5 . 17
40
40 47
% 10
40
40 44
When all costs are fixed, selling 1 additional unit increases gross profit by the selling price

73
Variable
Costs
Fixed
Costs
If sales decrease
by 10%, will the income
decrease be greater
in the All Fixed
Company?
74 Yes, the income decrease is greater in the All Fixed Company.
% 25
40
40 30

% 5 . 17
40
40 37

% 10
40
40 36


75
Variable
Costs
Fixed
Costs
Level of
Fixed Cost
Earnings
Volatility
High High
Low Low
Risk may be reduced by
converting fixed costs
into variable costs.

Chapter Overview
Cost Structures
Today
76
77
The composition of manufacturing costs has changed
substantially in recent years
Many formal cost systems were first implemented in the
early 1900s:
Direct labor represented a large proportion, sometimes 50% or
more, of the total manufacturing costs
Direct material costs were also substantial
Capacity-related (fixed) costs generally represented a small
fraction of total manufacturing costs
Cost Structures Today
78
Today, direct labor is only a small portion of
manufacturing costs
The cost of direct materials remains important,
representing 40% to 60% of the costs in many plants
The big change has been the vastly increased share of
total costs from capacity-related costs
79
The increase in fixed costs results from:
The shift toward greater automation, which requires more
production engineering, scheduling, and machine setup
activities
The emphasis on better customer service
The increase in support activities required by a proliferation of
multiple products
Both variable and fixed costs associated with design,
product development, distribution, selling, marketing,
and administrative activities have increased
80
Changing cost structures have caused cost systems
allocating indirect costs using volume measures to
become increasingly inaccurate in computing product
costs
Many costing systems take costs that did not vary
proportionally with volume, accumulate them, and then
allocate them using a measure of volume
These systems often underallocate costs to cost objects
(e.g., product lines) produced in low volumes
81
End of Chapter 16
Thats it
for
today!

Cost Volume Profit Analysis

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The percentage increased in income is greatest in the All Fixed Company.

The Effect of Operating Leverage

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