Ch18 Management Accounting 5e

20/01/2014
Chapter 18
Cost volume profit analysis
Copyright 2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith
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Outline
What is CVP analysis? The break-even point Graphing CVP relationships Target net profit Using CVP analysis for management decisions CVP analysis with multiple products Including income taxes in CVP analysis Practical issues in CVP analysis An activity-based approach to CVP analysis Financial planning models
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Cost volume profit (CVP) analysis

A technique used to determine the effects of changes in an organisations sales volume on its costs, revenue and profit Can be used in profit-seeking organisations and not-for-profit organisations
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The break-even point

The volume of sales where the total revenues and costs are equal, and the operation breaks even At this level of sales, there is no profit or loss Can be calculated for an entire organisation or for individual projects
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Break-even formulas
Fixed costs Unit contribution margin
Break - even point (in units) =
Break - even point (in sales dollar) =
Fixed costs Unit contribution margin ratio
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Terminology
Contribution margin (or variable costing) statement
An income statement that separates fixed and variable costs and calculates a contribution margin
Total contribution margin

The difference between the total sales revenue and the total variable costs The amount available to cover fixed costs and then contribute to profits
Unit contribution margin

The difference between the sales price per unit and the variable cost per unit (cont.)
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Terminology (cont.)
Contribution margin ratio
The unit contribution margin divided by the unit sales price The proportion of each sales dollar available to cover fixed costs and earn a profit
Contribution margin percentage

The contribution margin ratio multiplied by 100 The percentage of each sales dollar available to cover fixed costs and earn a profit
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Graphing cost volume profit relationships

Shows how costs, revenue and profits change as sales volume changes Five steps
1. 2. 3. 4. 5. Draw the axes of the graph Draw the fixed cost line Draw the total cost line Draw the total revenue line Break-even pointwhere the total revenue and total cost lines intersect
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Profit volume (PV) graph

Shows the total amount of profit or loss at different sales volumes The graph intercepts the vertical axis at the amount equal to the fixed costs The break-even point is the point at which the total profit/loss line crosses the horizontal axis
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Target net profit

A desired profit level determined by management The break-even formula can be sued to determine the target profit
Target sales volume =
Fixed costs + target profit Unit contribution margin
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Using CVP analysis for management decision making

Safety margin
Difference between the budgeted sales revenue and break-even sales revenue Gives a feel for how close projected operations are to the break-even point
Changes in fixed costs

Percentage change in fixed costs will lead to a similar increase in the break-even point (in units or dollars) Different fixed costs may apply to different levels of sales/production volume, and provide more than one break-even point (cont.)
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Using CVP analysis for management decision making (cont.)

Changes in the unit contribution margin
Change in unit variable costs, leads to new unit contribution margin and new break-even point An increase in unit variable costs will increase the breakeven point An increase in unit price will lower the break-even point
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Multiple changes in key variables

May involve, for example
Increasing unit prices Increasing selling prices Undertaking a new advertising campaign Leasing a new office
An incremental approach to analysis

Focuses on the differences in the total contribution margin, fixed costs and profits under the two alternatives
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CVP analysis with multiple products

Sales mix
The relative proportions of each type of product sold by the organisation
Weighted average unit contribution margin

The average of the products unit contribution margins, weighted by the sales mix
Fixed costs Break - even point = Weighted average unit contributi on margin
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Including income taxes in CVP analysis

Sales volume required to earn target after - tax profit
Fixed costs + =
target net profit after tax (1 - t )
unit contributi on margin
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Assumptions underlying CVP analysis

The behaviour of total revenue is linear The behaviour of total costs is linear over a relevant range
Costs can be categorised as fixed, variable or semivariable Labour productivity, production technology and market conditions do not change There are no capacity changes during the period under consideration
(cont.)
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Assumptions underlying CVP analysis (cont.)

For both variable and fixed costs, sales volume is the only cost driver The sales mix remains constant over the relevant range In manufacturing firms, the levels of inventory at the beginning and end of the period are the same
Thus, the number of units produced and sold during a period are equal
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CVP analysis and longer-term decisions

CVP analysis is usually regarded as a short-term or tactical decision tool Classification of costs as variable or fixed is usually based on cost behaviour over the short term The financial impact of long-term decisions is best analysed using capital budgeting techniques
Takes into account the time value of money
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Treating CVP analysis with caution

CVP analysis is merely a simplified model The usefulness of CVP analysis may be greater in less complex smaller firms, or stand-alone projects For larger firms, CVP analysis can be valuable as a decision tool for the planning stages of new projects and ventures
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An activity-based approach to CVP analysis

ABC categorises activities as unit, batch, product or facility level
Facility, product and batch activities are non-volume activity costs
Total batch, product and facility level costs Break - even point = Selling price per unit - costs per unit
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Limiting assumptions of CVP analysis using activity-based costs

Total batch level costs are dependent on the batch size and the break-even/target production level Management may change the batch size at certain production volume levels and this will change the break-even volume More complex models are needed where there are multiple products
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Financial planning models

Sensitivity analysis and CVP analysis
An approach that examines how an outcome may change if there are variations in the predicted data or underlying assumptions
Can be run using spreadsheet software, such as Excel Goal seek approaches
The analyst specifies the outcome, and the software specifies the necessary inputs
What-if analysis
The analyst specifies changes in assumptions and data to examine the effect of these changes on the outputs
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Summary
CVP analysis is a decision tool that can be used to assess the effects on changes in profit of changes in sales volume, sales price, sales mix and costs The break-even point is the sales level at which sales covers coststhere are zero profits The break-even formula can be modified to calculate target profit, and to include sales mix and income taxes CVP analysis has several assumptions which limit its usefulness for decision making Activity-based approaches and financial planning modelling can provide more sophisticated models
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20/01/2014

Cost volume profit (CVP) analysis

The break-even point

Break - even point (in units) =

Break - even point (in sales dollar) =

Fixed costs Unit contribution margin ratio

Total contribution margin

Unit contribution margin

Contribution margin percentage

Graphing cost volume profit relationships

Profit volume (PV) graph

Target net profit

Target sales volume =

Fixed costs + target profit Unit contribution margin

Using CVP analysis for management decision making

Changes in fixed costs

Using CVP analysis for management decision making (cont.)

Multiple changes in key variables

An incremental approach to analysis

CVP analysis with multiple products

Weighted average unit contribution margin

Including income taxes in CVP analysis

target net profit after tax (1 - t )

unit contributi on margin

Assumptions underlying CVP analysis

Assumptions underlying CVP analysis (cont.)

CVP analysis and longer-term decisions

Treating CVP analysis with caution

An activity-based approach to CVP analysis

Limiting assumptions of CVP analysis using activity-based costs

Financial planning models

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