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C H A P T E R

C H A P T E R . 2. Analyzing Cost-Volume- Profit Relationships. CVP - What Questions Does It Answer?. What happens to profits if we change our selling price?. What happens to profits if we change the number of units sold?. How many units do we need to sell to break even?.

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  1. C H A P T E R 2 Analyzing Cost-Volume- Profit Relationships

  2. CVP - What Questions Does It Answer? • What happens to profits if we change our selling price? • What happens to profits if we change the number of units sold? • How many units do we need to sell to break even? • How much sales revenue do we need to meet our pretax profit goal? • What happens to profits if we change our advertising expenses? • What happens to profits if we discontinue certain products?

  3. CVP Key Variables • Revenues– Price x Quantity • Fixed costs– Independent of volume • Variable costs– Dependent upon volume • Volume– Level of activity • Product mix– Different products • Efficiency & quality of production • Combinations of above

  4. What are Variable Costs? Costs that change in total in direct proportion to changes in activity level. Unit Cost: Constant Total Cost: Varies Total Cost Units Produced

  5. Define Relevant Range and Curvilinear Costs Relevant range: The range of operating level, or volume of activity, over which the relationship between total costs (variable + fixed) and activity level is approximately linear. Curvilinear costs:Variable costs that do not vary in direct proportion to changes in activity level but vary at decreasing or increasing rates due to economies of scale, productivity changes, and so on.

  6. Define Fixed Costs Costs that remain constant in total, regardless of activity level, at least over a certain range of activity. Unit Cost: Varies Total Cost: Constant Total Cost UnitsProduced

  7. Total fixed costs (Sales price per unit - Variable cost per unit) Fixed Costs are Used to Calculate Break-Even • What does break-even mean? • Break-even is the point where revenues equal all costs, neither profit nor loss is incurred. • What is the formula for break-even?

  8. Stepped costs change in total in a stair-step fashion (in large amounts) with changes in volume of activity. Relevant Range Cost Over the relevant range, stepped costs may appear to be fixed. Production Volume Define Stepped Costs

  9. Mixed costs contain both variable and fixed cost components. For Example: A leased machine might cost $1,000 per month (fixed) plus $20 per hour of usage (variable). Variable Cost Fixed Production Volume Define Mixed Costs

  10. Regression Line What is the Scattergraph (Visual-Fit) Method? A method of segregating the fixed and variable components of a mixed cost by plotting on a graph total costs at several activity levels and drawing a regression line through the points. Cost Volume of Activity

  11. Variable costs per unit are equal to the slope of the regression line. Variable Costs Scattergraph (Visual-Fit) Fixed costs are represented by the intersection of the regression line and the vertical axis. Cost Fixed Costs Volume of Activity

  12. Define the High-Low Method A method of segregating the fixed and variable components of a mixed cost by analyzing the costs at the highest and lowest activity levels within a relevant range.

  13. Step 1:Identify the highest and lowest activity levels. High-Low Method Cost Volume of Activity

  14. Step 2: Determine the differences between the high and low points. High-Low Method Cost Volume of Activity

  15. Step 3: Calculate the variable cost per unit by finding the slope of the regression line between the two points (which reflect total mixed costs). High-Low Method Cost Variable Cost per Unit Rise = Run Volume of Activity

  16. Contribution Margin Approach Contribution margin is the portion of sales revenue available to cover fixed costs and provide a profit. Sales revenue – Variable costs = Contribution margin – Fixed costs = Profit

  17. Total Sales revenue $1,000,000 Less variable costs 400,000 Contribution margin $ 600,000 Contribution Margin Approach • If a computer sells for $2,000 with variable costs of $800 per computer and fixed costs of $350,000 per year: • What is the total contribution margin on 500 computers?

  18. Contribution Margin Approach • If a computer sells for $2,000 with variable costs of $800 per computer and fixed costs of $350,000 per year: • What is the total contribution margin on 500 computers? • What is the contribution margin per unit? TotalPer Unit Sales revenue $1,000,000 $2,000 Less variable costs 400,000 800 Contribution margin $ 600,000$1,200

  19. Contribution Margin Approach • If a computer sells for $2,000 with variable costs of $800 per computer and fixed costs of $350,000 per year: • What is the total contribution margin on 500 computers? • What is the contribution margin per unit? • What is the contribution margin ratio? Total Per Unit Ratio Sales revenue $1,000,000 $2,000 100% Less variable costs 400,000 800 40% Contribution margin $ 600,000 $1,200 60%

  20. Total Per Unit Ratio Sales revenue $1,000,000 $2,000 100% Less variable costs 400,000 800 40% Contribution margin $ 600,000 $1,200 60% Less fixed costs 350,000 Profit $ 250,000 Contribution Margin Approach If a computer sells for $2,000 with $800 variable costs per computer and $350,000 fixed costs per year: • What is the total contribution margin on 500 computers? • What is the contribution margin per unit? • What is the contribution margin ratio? • What is the total dollar profit after one year?

  21. Sales price x units Variable cost x units Independent of units Target Income $2,000(x) - $800(x) - $350,000 = 0 1,200(x) - $350,000 = 0 1,200(x) = 350,000 x = 292 computers The Break-Even Point Example: How many computers will the store have to sell in order to break even if one computer sells for $2,000, costs $800 to make (variable cost), and fixed costs are $350,000?

  22. Multiple Variable Changes Costs independent of units Sales price x units Variable cost x units Zero for break-even OR OR etc.

  23. Target Income = Revenue - variable - fixed X = $1,700(500) - $700(500) - $325,000 X = $850,000 - $350,000 - $325,000 X = $175,000 or a 30% decrease in profit Multiple Variable Changes Assume prior year profits of $250,000 for The Store. What if this year the price of our $2,000 computers is reduced by 15 percent due to a decrease in variable costs from $800 to $700 per computer and a decrease in fixed costs from $350,000 to $325,000? What would be the effect on target income (or profit) assuming the production of 500 computers?

  24. Revenue Line Break-Even Point Revenue & Cost $584,000 Total Cost Line Fixed Costs ($350,000) 292 Number of Computers Sold The Graphic ApproachIdentify the Break-Even Point, Revenue Line, Total Cost Line, and Fixed Costs

  25. What are the Limiting Assumptionsof C-V-P Analysis? • The behavior of revenues and costs is linear throughout the relevant range. • All costs can be categorized as either fixed or variable. • Sales mix does not change.

  26. If a change in quality or production time either increases cost or decreases production speed, careful consideration should be given to the change. How Do Quality & Time Affect C-V-P Decisions? • Change in Quality: • - Will it increase cost? • - Will it decrease production speed? • Change in Production Time: • - Will it increase cost? • - Will it decrease production speed?

  27. Expanded MaterialLearning Objective 8 • Explain the effects of sales mix on profitability.

  28. Can Openers Microwaves Total Amount % Amount % Amount % = = Product Revenue Total Revenue 5,000 30,000 17% Sales Mix Sales revenue $5,000 100% $25,000 100% $30,000 100% Less variable costs 3,000 60% 20,000 80% 23,000 77% Contribution margin $2,000 40% $ 5,000 20% $ 7,000 23% Sales mix 17% 83% 100%

  29. Sales Mix To maximize profit in a company with multiple products, management should emphasize products with the highest contribution margin ratio. Which product should they choose? Can Openers Microwaves Total Amount % Amount % Amount % Sales revenue $5,000 100% $25,000 100% $30,000 100% Less variable costs 3,000 60% 20,000 80% 23,000 77% Contribution margin $2,000 40% $ 5,000 20% $ 7,000 23% Sales mix 17% 83% 100%

  30. Expanded MaterialLearning Objective 9 • Describe how fixed and variable costs differ in manufacturing, service, merchandising, and e-commerce organizations, and illustrate these differences with the operating leverage concept.

  31. The extent to which fixed costs are part of a company’s cost structure. • The higher the proportion of fixed costs to variable costs, the faster income increases or decreases with sales volume. Contribution Margin Net Income Operating Leverage Define Operating Leverage

  32. Operating Leverage For example: Assume the following data. Total Per Unit Ratio Sales revenue $1,000,000 $2,000 100% Less variable costs 400,000 800 40% Contribution margin $ 600,000 $1,200 60% Less fixed costs 450,000 Net income $ 150,000 • What is the operating leverage? Operating leverage = 2.4 • What happens to net income if sales are increased by 20 percent? Net income increases 48% • Increase fixed costs to $450,000. What is the operating leverage (no sales increase)? Operating leverage = 4 • Now what happens to net income if sales are increased by 20 percent? Net income increases 80%

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