Chapter 18

Cost volume profit analysis

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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

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Cost volume profit (CVP) analysis

A technique used to determine the relationship between selling prices, sales volumes, costs and profits CVP analysis is a way to answer a number of important questions about the profitability of a companies products/services.Can be used by companies which work with multiple products/services or single products/services. Can be used in profit-seeking organisations and not-for-profit organisations

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Cost volume profit (CVP) analysis

CVP analysis provides information about
Products or services to emphasise Sales needed to achieve target profit Revenue required to avoid losses Whether to increase fixed costs Budget for discretionary expenses Risk to which fixed costs expose firm

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The break-even point

The breakeven point (BEP) is where total revenue equals total costs At this level of sales, there is no profit or loss Can be calculated for an entire organisation (multiple products) or for individual projects(single products)

Sales $ 250,000 Less: variable expenses 150,000 Contribution margin 100,000 Less: fixed expenses 100,000 Net income $ -

BEP

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Test Time..! CVP Analysis is important because: a. the teacher says so. b. it sounds cool to say "see vee pee". c. it is a good way to analyze the profitability of a company's products or services.

d. I haven't a clue.

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Break-even formulas
(For single product)

Fixed costs Break - even point (in units) = Unit contributi margin on

SP - VC
Break - even point (in sales dollar) = Fixed costs Unit contribution margin ratio

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Terminology
Contribution margin
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
Contribution margin ratio

(cont.)

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 The contribution margin as a percentage of total sales is referred to as contribution margin ratio (CM Ratio).

CMR

CM Selling Price

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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Lets Apply ! Calculation / Computation of Contribution Margin Ratio

Consider the following contribution margin income statement of Cadbury Ltd in which sales revenues, variable expenses, and contribution margin are expressed as percentage of sales.
Per Unit Percent of Sales $100,000 $250 100% 60,000 150 60% ------------ ------------ -----------$40,000 $100 40% ====== ====== 35,000 -----------$5,000 Total

Sales (400 units) Less variable expenses Contribution margin Less fixed expenses Net operating income

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According to above data of Cadbury Ltd the computations are:

Contribution Margin Ratio = (Contribution Margin / Sales) 100 = ($40,000 / $100,000) 100 = 40%

In a company that has only one product such as CM ratio can also be calculated as follows: Contribution Margin Ratio = (Unit contribution margin / Unit selling price) 100 = ($100 / $250) 100= 40%

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Graphing cost volume profit relationships

CVP 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(refer to on graph)

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Refer to page 920 of text)

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Target net profit

A desired profit level determined by management The break-even formula can be used to determine the target profit

Fixed costs + target profit Target sales volume = Unit contributi margin on

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Using CVP analysis for management decision making

Safety margin
Difference between the budgeted sales revenue and breakeven sales revenue. Gives a feel for how close projected operations are to the break-even point Eg: Curl Inc has a break-even point of $200,000.If actual sales are $250,000, the safety margin is $50,000 or 100 surf boards.
Break-even sales 400 units $ 200,000 120,000 80,000 80,000 $ Actual sales 500 units $ 250,000 150,000 100,000 80,000 $ 20,000

Sales Less: variable expenses Contribution margin Less: fixed expenses Net income

(cont.)
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Using CVP analysis for management decision making

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

Example: Curl is currently selling 500 surfboards per year. The owner believes that an increase of $10,000 in the annual advertising budget would increase sales to 540 units. Should the company increase the advertising budget?
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Solution: Changes in Fixed Costs

Current Sales (500 Boards) Sales $ 250,000 Less: variable expenses 150,000 Contribution margin $ 100,000 Less: fixed expenses 80,000 Net income $ 20,000 Proposed Sales (540 Boards) $ 270,000 162,000 $ 108,000 90,000 $ 18,000

540 units $500 per unit = $270,000 $80,000 + $10,000 advertising = $90,000
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Solution: Changes in Fixed Costs

Sales will increase by $20,000, but net income decreased by $2,000.
Current Sales (500 Boards) Sales $ 250,000 Less: variable expenses 150,000 Contribution margin $ 100,000 Less: fixed expenses 80,000 Net income $ 20,000 Proposed Sales (540 Boards) $ 270,000 162,000 $ 108,000 90,000 $ 18,000

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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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Including income taxes in CVP analysis

Sales v olumerequired to earn target af ter - tax prof it

Fixed costs + =

target net prof it af ter tax (1 - t )

unit contribution margin

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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Test time!
Which of the following changes will affect the unit contribution margin?
.

A. Changes in fixed cost B. Changes in variable cost per unit C. Changes in selling price per unit D. Both changes in variable cost per unit AND changes in selling price per unit

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Test time! - answer

Which of the following changes will affect the unit contribution margin?
.

A. Changes in fixed cost B. Changes in variable cost per unit C. Changes in selling price per unit D. Both changes in variable cost per unit AND changes in selling price per unit

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CVP analysis single product

Coco Ltd produced and sold 45 000 units of a single product last year. Data concerning the years profit and loss statement are as follows:
Sales revenue Manufacturing costs Variable Fixed Selling costs Variable Fixed Administrative costs Variable Fixed $1 350 000 $585 000 $270 000 $40 500 $54 000 $184 500 $108 000

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Required:
1.What was Cocos total contribution margin for the year? 2. What was Cocos break-even point (rounded) in unit sales?

3.What was Cocos break-even point in dollar sales?

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Sales (45,000) $1,350,000 less VC 810,000 CM 540,000 less FC 432,000 PBT 108,000

$30 18 12

FC /CM =BE 432,000 / $12 = 36,000 units

36,000 units to BE x $30 p/u = $1,080,000

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Are we good ?

Lets try multiple product

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CVP analysis with multiple products

When a company sells more than one product the CVP calculations must be adjusted for the sales mix

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 (CM x sales mix)
Fixed costs Break - ev en point = Weighted av erage unit contribution margin

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Example: CVP analysis with multiple products. Lets assume Curl sells surfboards, sail boards and wind boards. Curl provides us with the following information.

- Fixed Costs are said to be $498,875

- Forecasted sales are as follows:

Forecasted volume (units)

Surf 10 000

Sail 18 000

Wind 12 000

Total 40 000

-Expected selling price,variable costs and contribution margin for each

board:

Price per unit VC per unit CM per unit

Surf $200 75 $125

Sail $700 250 $450

Wind $800 300 $500

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REQUIRED:

1. Calculate the sales mix for the 3 products 2. Calculate the WACM per unit

3. Calculate the BEP in total units

4. Calculate the BEP per each unit 5. Calculate the WACM ratio 6. The company wants to achieve a targeted after tax profit of $100,000. What pre-tax profit must the company earn to achieve their goal. Assume a tax rate of 30% applies. 7. Units needed to be sold to meet target profit. 8. Target revenues
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SOLUTION Curl Ltd:

1. Calculate the sales mix for the 3 products
Forecasted volume (units) Expected sales mix(units)

Surf Sail 10 000 18 000 25% 45%

Wind 12 000 30%

Total 40 000 100%

10,000 / 40,000=25%

12,000 / 40,000=30%

18,000 / 40,000=45%

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SOLUTION Curl Ltd:

2.Calculate the WACM per unit
The weighted average CM per unit is the average CM per unit for multiple products multiplied by the sales mix It is used to determine the breakeven point or targeted profit in units

CM per unit Sales mix Weighted avg CM (CM x sales mix)

SURF $125 25%

$31.25

SAIL $450 45%

$202.50

WIND $500 30%

$150

Weighted average contribution margin $31.25 + $202.50 + $150 = $383.75

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SOLUTION Curl Ltd: 3. Calculate the BEP total units Formula: Fixed Costs / WACM = BE units $498,875 / $383.75 = 1,300 units

4. Calculate the BEP for each product

1,300 units
(1300 x .25 =325) (1300 x .45 =585)

(1300 x .30 = 390)

5. Calculate the WACM ratio

.

$383.75 = 63.47% ($200 x 0.25) + ($700 x 0.45) + ($800 x 0.30)

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SOLUTION Curl Ltd: 6. What pre-tax profit must the company earn to achieve their goal. Assume a tax rate of 30% applies.
$100 000 = $142,857 (see next pp for reconciliation) (1 0.30)
7. Units needed to be sold to meet target profit. $498,875 + $142 857 = 1,672 units FC + DPBT $383.75 per unit WACM

8. Total dollar sales required to earn a target net profit. $498,875 + $142 857 = $1,011,079.20 FC + TP 63.47% CMR

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Profit before tax lessTax 30%

$142,857 42,857

Profit after tax

$100,000

(cont.)
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Now taking the example you have already calculated:The company is looking at some structural changes and in doing so believes that Fixed costs are going to increase by 20% due to additional storage space they need to hire. Also the company has been notified that the fibreglass they use to make the surf product is going to increase by $10 per unit and due to a change in supplier, variable costs for the wind product will reduce by $20 per unit. Based on the new information above advise management of Curl Ltd what the new breakeven point would be in total units.Discuss results.

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Suggested Answer
SURF SAIL 0.25 0.45 200 700 85 250 115 450 28.75 202.50 WIND 0.3 800 280 520 156.00

SP LESS VC CM WACM

387.25

FC/WACM=BE

598,650/ 387.25 = 1,545.90

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Assumptions & limitations 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

For both variable and fixed costs, sales volume is the only cost driver
(cont.)
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Assumptions & limitations underlying CVP analysis (cont.)

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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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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BREAKEVEN
Holden posts 'break-even' profit result
Posted

Tue Jul 29, 2008 6:20pm AEST

Car-maker Holden has reported a vast improvement in its financial performance for last year, with an almost break-even result. Holden posted a loss of $6 million last year, which is a dramatic improvement on the previous year when the company recorded a $146 million deficit. The company says the result was boosted by better sales of its luxury car lines and the first full year of production of its new model Commodore. The Elizabeth plant manufactured almost 108,000 vehicles last year, with 57,300 Commodores sold in Australia. But restructuring costs at the Elizabeth plant after the end of production of the VZ model cost Holden $77.5 million and exchanges rates hurt the company in the global market.
http://www.abc.net.au/news/stories/2008/07/29/2318127.htm

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Air India likely to break even in 2 years

New Delhi, July 22 Air India should be in a position to break even at the current revenue levels and passenger load factors in the next two years. Currently the airline has revenues of Rs 16,000 crore and on an average, reports a passenger load factor of about 60-65 per cent on a network wide basis. This is said to be one among the various options presented to the airline as part of the short- and long-term road- map drawn up SBI Caps. The airline had given SBI Caps the mandate to draw up a financial restructuring, revised business plan and cost reduction and revenue generation initiatives to be adopted by the airline. Sources told Business Line that SBI Caps will only present a true picture of the financial position of the airlines and also point out measures to help in making its operations become more financially viableThe airline has adopted various measures to improve its financial position, including constituting a turn around committee drawn from senior management and unions to look at all areas of cost reduction. http://www.thehindubusinessline.com/2009/07/23/stories/2009072351601000.htm
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Etihad Airways on course to break even by 2010

by Amy Glass on Tuesday, 06 May 2008

Abu Dhabi-based Etihad Airways issaid it was break even by 2010, ON COURSE: Etihad on target to on a company executiveto break even by 2010. Tuesday. target told ArabianBusiness.com on Speaking at the Arabian Travel Market (ATM) in Dubai, Geert Boven, executive vice president, sales and services, said while the UAEs national carrier was not announcing financial results yet, the company was confident of hitting its economic targets. We are very much in the startup phase - which requires a lot of investment - and we are looking forward to breaking even in 2010, Boven said.
http://www.arabianbusiness.com/518580-etihad-airways-to-break-even-by-2010-?ln=en

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