Prepared by Diane Tanner University of North Florida

1. Chapter 3 Cost-Volume-Profit Analysis Prepared by Diane Tanner University of North Florida

2. Cost-Volume-Profit (CVP) Analysis 2 • A very powerful management tool • Helps explain interactions between • Selling prices of products • Volume or level of activity • Per unit variable costs • Total fixed costs • Mix of products sold CVP assesses the relationship between costs (fixed and variable), activity levels and profits.

3. CVP Terminology 3 • Selling price • The amount for which one unit of product is sold • Sales revenue • Selling price per unit multiplied by the number of units sold • Total cost • Total variable costs plus total fixed costs • Variable cost (VC) • A variable cost per unit of product • Total fixed costs (FC)

4. Cost and Profit Equations Cost equation Total cost = (VC/unit)(# of units) + Total FC i.e., TC = VCx + FC Profit equation Sales revenue ‒ Total cost = Profit Or (SP/per unit)(# of units) ‒ Total cost = Profit Or SPx ‒ VCx ‒ FC = profit Parallels the components on the variable costing income statement

5. Assumptions in CVP Analysis • Costs can be accurately separated into their variable and fixed components • Both unit variable costs and total fixed costs remain constant within the relevant range • Inventory levels are zero or do not change • Costs are linear • Sales mix is constant (applies to companies with multiple products)

6. CVP Graph 6 Three primary CVP graph lines Total Revenue Dollars Total Cost Fixed costs Units

7. Breakeven Point • The point where • Sales revenue equals total cost • Contribution margin equals fixed costs • Profit is zero • Break-even profit equation • SPx – VCx – FC = 0 • Activity below the break-even point creates a loss • Activity above the break-even point generates a profit

8. Breakeven Point 8 • Total sales revenue = total expenses = VCx + FC Total Revenue Profit Area Break-even point Dollars Total Cost Loss Area Fixed costs Units

9. Target Profit • Target profit is the level of profit a company desires to achieve • CVP can be used to determine the sales volume needed to achieve a target profit • ‘Before tax’ target profit equation • SPx – VCx – FC = Target Profit • ‘After tax’ target profit equation • (SPx– VCx – FC)(1 – TR) = Target Profit Where TR is the income tax rate

10. Margin of Safety 10 Margin of safety is…… • The amount by which sales (revenue or units) can drop before losses begin to be incurred • A cushion available to management before trouble (a loss) occurs • Can be measured in • Unit sales or • Sales dollars Margin of safety = Total sales ‒Break-even sales

11. What-If Analysis • Using the profit equation, managers can change selected variables to see the effect on profit, units to be sold, or sales revenue. • Variables to be changed • Selling price • Fixed costs • Variable costs

12. Operating Leverage 12 • What is cost structure? • The relative proportion of fixed and variable costs in an company • Higher proportions of fixed costs compared to variable costs • More sensitive to changes in sales • More risk • Higher operating leverage • Higher proportions of variable costs compared to fixed costs • Less sensitive to changes in sales • Less risk • Lower operating leverage

13. 13 Degree of Operating Leverage • A measure of how sensitive net operating income is to percentage changes in sales • A risk indicator Contribution MarginNet Operating Income Degree of Operating Leverage = Company ACompany B $70,000 $18,000 $49,000 $18,000 = 3.89 = 2.72 Higher degree of operating leverage indicates higher proportion of fixed costs and higher risk.

14. Pushing Products to Customers 14 Goal is to generate the largest profit If customers prefer to buy one product and do not care which one they buy Push the product with the higher contribution margin per unit Push the product with the higher contribution margin ratio (i.e., the highest profit out of each sales dollar) If customers prefer to spend a fixed sum of money and do not care which products they buy

15. What is sales mix? The relative proportion in which a company’s products are sold Based on the premise that different products have different selling prices, cost structures, and contribution margins Two ways to express Unit sales mix 2000 : 8000 1 : 4 Sales Mix 15 • Revenue sales mix • 4000 : 6000 • 2 : 3

16. Multiproduct Analysis Two approaches • Contribution approach • Based on the weighted average contribution margin for all products combined • Bundle approach • Based on the unit contribution margins of each product weighted by the sales mix

17. Weighted Average Approach 17 • To determine the number of units to be sold for multiple products, use • Weighted average CM per unit, and • Unit sales mix • To determine the sales revenue dollars to be sold for multiple products, use • Weighted average CM ratio, and • Revenue sales mix

18. The End