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Cost‐Volume‐Profit (CVP) Analysis
(Chapter 3, Horngren et al)
Learning objectives
1. Explain Contribution Margin and the
CVP framework
2. Determine the breakeven point and a
target operating income
3. How income taxes affect CVP analysis
4. How managers use CVP analysis to
make decisions
5. Sensitivity analysis and risk
management
Learning objectives
6. Use CVP analysis for cost planning
7. CVP analysis to a company producing
multiple products
8. CVP analysis in service and not‐for‐
profit organizations
9. Contribution margin versus gross
margin
The problem of fixed cost in a U2
rock concert
On its recent world tour (2015), U2:
• Performed on a 164‐foot‐high stage that resembled a spaceship;
• Used 3 separate stages, each costing nearly USD 40 million;
• Incurred additional expenses of USD 750,000 daily;
• Sold tickets as little as USD 30 per ticket;
• Racked up almost USD 736 million in ticket and merchandise sales
by the end of the tour
The problem of fixed cost in the
airline industry
• Very high fixed cost to maintain a fleet
• Profits for most airline come from the last 2 to
5 passengers who board each flight
• How can CVP help?
What is CVP? How is it used?
• Managers want to know how profits will change
as the units sold of a product or service change.
• Managers like to use “what‐if” analysis to
examine the possible outcomes of different
decisions so they can make the best one.
• In Week 2, we discussed total revenues, total
costs and income. In this week, we take a closer
look at the relationship among the elements
(selling price, variable costs, fixed costs).
1. Cost–Volume–Profit Equation
Keep in mind the following:
Selling Price * Quantity of Units Sold = Revenue
Unit Variable Costs * Quantity of Units Sold = Variable Costs
Revenue – Variable Costs = Contribution Margin
Contribution Margin – Fixed Costs = Operating Income
Assumptions
used in CVP analysis
• Changes in production/sales volume are the sole cause for cost and
revenue changes.
• Total costs consist of fixed costs and variable costs.
• Revenue and costs behave and can be graphed as a linear function (a
straight line).
• Selling price, variable cost per unit, and fixed costs are all known and
constant.
• In many cases only a single product will be analyzed. If multiple products
are studied, their relative sales proportions are known and constant.
• The time value of money (interest) is ignored.
1. Contribution Margin
• The basic CVP equation yields an extremely
important and powerful tool extensively used
in cost accounting: contribution margin (CM).
• Contribution margin equals revenue less
variable costs.
• Contribution margin per unit equals unit
selling price less unit variable costs or can be
obtained by taking contribution margin
divided by number of units sold.
1. Contribution Margin
• Emma’s decision (p. 89, L.O.1)
• Emma’s contribution margin (p. 90)
• Exhibit 3‐1
CVP: Contribution Margin
Additional calculations
You can also calculate:
Contribution margin which is equal to the
contribution margin per unit multiplied by the
number of units sold.
Contribution margin percentage which is the
contribution margin per unit divided by unit
selling price or Contribution margin divided by
revenue. (Emma’s C.M.% = 0.4 or 40%)
Atthe breakeven point, a firm has no profit
or loss at the given sales level. Breakeven is
where:
Sales – Variable Costs – Fixed Costs = 0
Calculation of breakeven number of units
Breakeven Units = Fixed Costs _
Contribution Margin per Unit
Calculation of breakeven revenues
Breakeven Revenue = Fixed Costs _
Contribution Margin Percentage
Thebreakeven point formula can be
modified to become a profit planning tool by
adding Target Operating Income to fixed
costs in the numerator.
Revenue = Revenue =
$10,000 $12,500
Problem‐Solving
Do Problem 3‐16 (10‐15 minutes)
Do Problem 3‐17 (10‐15 minutes)
3. CVP and Income Taxes
After‐tax profit (Net Income) can be
calculated by:
Net Income = Operating Income * (1‐Tax Rate)
Net income can be converted to operating
income for use in CVP equation
Operating Income = I I Net Income I
(1‐Tax Rate)
• The margin of safety calculation answers a very
important question:
• If budgeted revenues are above the breakeven
point, how far can they fall before the breakeven
point is reached. In other words, how far can
they fall before the company will begin to lose
money.
Margin of Safety (pp. 101‐102,
L.O. 5)
• An indicator of risk, the margin of safety
(MOS), measures the distance between
budgeted sales and breakeven sales:
– MOS = Budgeted Sales – BE Sales
• The MOS ratio removes the firm’s size
from the output, and expresses itself in
the form of a percentage:
– MOS Ratio = MOS ÷ Budgeted Sales
6. CVP and Cost Planning
(pp.102‐103, L.O.6)
Managers make strategic decisions that
affect the cost structure of the company.
The cost structure is simply the
relationship of fixed costs and variable
costs to total costs.
We can use CVP‐based sensitivity analysis
to highlight the risks and returns as fixed
costs are substituted for variable costs in a
company’s cost structure.
The risk‐return trade‐off across alternative
cost structures can be measured as
operating leverage.
Operating Leverage
Operating leverage (OL) describes the effect that
fixed costs have on changes in operating income
as changes occur in units sold and contribution
margin.
OL = Contribution Margin
Operating Income
Notice that the difference between the numerator
and the denominator in our formula = our fixed
costs.
USING OPERATING LEVERAGE TO ESTIMATE CHANGES
IN OPERATING INCOME
The formula to estimate the change in operating
income that will result from a percentage
change in sales is:
Operating Leverage X % Change in Sales
If sales increase 50% and operating leverage is
1.67, you should expect operating income to
increase 83.5%.
Problem‐solving
Do problem 3‐26 (10 minutes)
7. Effects of Sales Mix on CVP
• The formulae presented to this point have assumed a
single product is produced and sold.
• A more realistic scenario involves multiple products
sold, in different volumes, with different costs and
different margins.
• In this case, we use the same formulae, but use
average contribution margins for the multiple
products.
• This technique assumes a constant mix at different
levels of total unit sales.
Multi‐Product CVP Analysis
If all fixed costs are traceable to individual products,
then the organization can develop a separate CVP
model for each product
Alternatively, the multi‐product firm can make an
assumption regarding a standard sales mix in which
its products are sold
Sales mix can be determined on the basis of sales
dollars or unit sales
The assumption of sales mix allows the firm to
calculate and use a weighted‐average contribution
margin (cm) per unit and weighted average cm ratio
to complete the multi‐product CVP analysis
Example: Multi‐Product CVP Analysis
Windbreakers, Inc. sells light‐weight sports/recreational jackets
and currently has three products: Calm, Windy, and Gale. Total
(joint) fixed costs for the period are expected to be $168,000, and
we assume the windbreakers’ sales mix, measured by sales
dollars, will remain constant. Additional information is
provided below. (Since sales mix is constant in $, we will use the
contribution margin ratio in the analysis. See next slide…)
Calm Windy Gale Total
Last period's sales $ 750,000 $ 600,000 $ 150,000 $ 1,500,000
Percent of sales 50% 40% 10% 100%
Price $ 30 $ 32 $ 40
Unit variable cost 24 24 36
Contribution margin $ 6 $ 8 $ 4
Contribution margin ratio 20% 25% 10%
Example: Multi‐Product CVP (continued)
From this information, we can calculate the wtd. avg. cm ratio:
Weighted-average CMR = 0.5(0.2) + 0.4(0.25) + 0.1(0.1) = 0.21
The breakeven point for all three products can be calculated
as follows:
Y = 168,000/0.21
Y= $800,000
This means that for Windbreakers to break even, $800,000 of all three
products must be sold in the same proportion as last year's sales mix.
The sales for each product need to be as follows:
For Calm 0.5($800,000) = $400,000
For Windy 0.4($800,000) = 320,000
For Gale 0.1($800,000) = 80,000
$800,000
8. CVP for SERVICE and Not‐
For‐Profit organizations
CVP isn’t just for merchandising and
manufacturing companies.
Service and Not‐for‐Profit businesses need to
focus on measuring their output which is
different from the units sold that we’ve been
dealing with.
For example, a service agency might measure
how many persons they assist or an airline
might measure how many passenger miles they
fly. (p. 108, L.O. 8)
9-30
9. Contribution Margin
versus Gross Margin
9-31
Additional Problems
3‐22, 3‐23, 3‐25, 3‐28,
329-32