Cost-Volume-Profit Analysis

Short Term Business Decisions

Teacher: Saqib Aziz FFBC, Univ-Lille2 Copy right:Pearson Education
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Economic & Accounting view of Cost

Economist view: long term and wide ranging output (Cost-Revenue interaction in profit making; curved lines) Accountant view: Short term perspective focused on limited range of activity (straight line graph)

Cost-Volume-Profit (CVP) Analysis

Is a powerful tool that helps managers make important business decisions Is a relationship among costs, volume, and profit or loss Determines how much the company must sell each month just to cover costs or to break even Helps managers decide how sales volume would need to change to achieve the same profit level

Components of CVP Analysis

CVP analysis relies on the interdependency of five components or pieces of information
Sales price per unit Volume sold Variable costs per unit Fixed costs Operating income

If you know or can estimate four of these five components, you can compute the remaining unknown amount
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CVP Assumptions
1. Change in volume is only factor that affects costs 2. Managers can classify each cost as either variable or fixed
These costs are linear throughout relevant range

3. Revenues are linear throughout relevant range 4. Inventory levels will not change 5. The sales mix of products will not change
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CVP Example Facts: Kays Posters

Kay has an e-tail poster business. She currently sells each poster for $35, while each poster has a variable cost of $21. Kay has fixed costs of $7,000. Kay is currently selling 550 posters. Kays relevant range extends from 0 to 2000 posters a month. Beyond this level he needs upgradation of site and an employee to handle increase in volume.
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Contribution Margin Income Statement

Kays e-tail poster example from prior slide Sales revenue (550 posters)..................................... $ 19,250 Less: Variable expenses ............................................ (11,550) Contribution margin ................................................. 7,700 Less: Fixed expenses.................................................. (7,000) Operating income...................................................... $ 700

Unit Contribution Margin

Kays e-tail poster example from previous slides Sales price per unit - Variable costs per unit Contribution margin per unit Now assume sales are 650 units: Contribution margin ( 650 sales X $14) - Fixed cost Operating Income $ 9,100 (7,000) $ 2,100 $ 35 (21) $ 14

Contribution Margin Ratio

Contribution margin ratio = percentage of each sales dollar that is available for covering fixed expenses and generating a profit. Contribution margin ratio Unit contribution margin = $14 Sales price per unit $35 = 40%

Contribution margin ratio

Contribution margin = $ 7,700 Sales revenue $19,250

= 40%

Numbers above are from the Kays e-tail poster example on previous slides.

Example 1
Bay Cruiseline offers nightly dinner cruises off the coast of Miami, San Francisco, and Seattle. Dinner cruise tickets sell for $50 per passenger. Bay Cruiselines variable cost of providing the dinner is $20 per passenger, and the fixed cost of operating the vessels (depreciation, salaries, docking fees, and other expenses) is $210,000 per month. The companys relevant range extends to 15,000 monthly passengers. a. What is the contribution margin per passenger? Sales revenue (1 passenger)..................................... $ 50 Less: Variable expenses ............................................ (20) Contribution margin ................................................. 30
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Example1 (continued)
b. What is the contribution margin ratio? Contribution margin ratio = Unit contribution margin = $ 30 Sales price per unit = $ 50 = 60%

c. Use the unit contribution margin to project operating income if monthly sales total 10,000 passengers.

10,000 x $30 = $300,000

d. Use the contribution margin ratio to project operating income if monthly sales revenue totals $400,000. Contribution margin ( $400,000 sales X 60%) $ 240,000 Fixed cost (210,000) Operating Income $ 30,000
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Example 2
Bay Cruiseline offers nightly dinner cruises off the coast of Miami, San Francisco, and Seattle. Dinner cruise tickets sell for $50 per passenger. Bay Cruiselines variable cost of providing the dinner is $20 per passenger, and the fixed cost of operating the vessels (depreciation, salaries, docking fees, and other expenses) is $210,000 per month. The companys relevant range extends to 15,000 monthly passengers.

If Bay Cruiseline sells an additional 500 tickets, by what amount will its operating income increase (or operating loss decrease)? Contribution Margin per unit x additional tickets 500 tickets X $30 = $15,000
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CVP & Breakeven Point

Breakeven point:

Sales level at which operating income is zero

If sales above breakeven, then profit If sales below breakeven, then loss

Fixed expenses = total contribution margin Total sales = total expenses

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Calculating Breakeven Point

Three approaches to calculating breakeven:

1.Income statement approach 2.Shortcut approach using unit contribution margin 3.Shortcut approach using contribution margin ratio (sales dollar)

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Income Statement Approach

Contribution Margin Income Statement for Kays e-tail
Sales - Variable Expenses Contribution Margin - Fixed Expenses Operating Income

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Short-Cut Approach to Calculating Breakeven Using the Unit Contribution Margin

Units sold = Fixed expenses + Operating income Contribution margin per unit $7,000 + $0 $14

Units sold =

= 500 posters

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Short-Cut Using the Unit Contribution Margin Ratio

Sales in $ = Fixed expenses + Operating income Contribution margin ratio $7,000 + $0 0.40 $17,500

Sales in $ =

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Finding the Volume Needed for a Target Profit Using Unit CM

CVP analysis helps managers determine what they need to sell to earn a target amount of profit.
Units sold = Units sold = Fixed expenses + Operating income Contribution margin per unit $7,000 + $4,900 $14 = $11,900 $14

= 850 posters
= 850 posters x $35 = $29,750
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Finding the Volume Needed for a Target Profit Using Ratio

CVP analysis helps managers determine what they need to sell to earn a target amount of profit.
Units sold = Fixed exp + Target operating income Contribution margin ratio $7,000 + $4,900 0.40 $11,900 0.40

Units sold =

= 29,750 posters
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Example 3
Use the information from the Bay Cruiseline Data Set to compute the number of dinner cruise tickets it must sell to break even. a. Use the income statement equation approach.

($50 x units) ($20 x units) - $210,000 = $0 ($50 $20 ) x units - $210,000 = $0 $30 x units = $210,000 units = $210,000/$30 units = 7,000

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Example 3 (continued)
Use the information from the Bay Cruiseline Data Set to compute the number of dinner cruise tickets it must sell to break even. b. Using the shortcut unit contribution margin approach, perform a numerical proof to ensure that your answer is correct. Units sold = Units sold = Units sold = = Fixed expenses + Operating income Contribution margin per unit $210,000 + $0 $30 $210,000 $30 7,000 tickets
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Example 3 (continued)
Use the information from the Bay Cruiseline Data Set to compute the number of dinner cruise tickets it must sell to break even. c. Use your answers from a and b to determine the sales revenue needed to break even.

7,000 units to break even X $50 sales price = $350,000

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Example 3 (continued)
Use the information from the Bay Cruiseline Data Set to compute the number of dinner cruise tickets it must sell to break even. d. Use the shortcut contribution margin ratio approach to verify the sales revenue needed to break even. Sales in $ = Sales in $ = Sales in $ = = Fixed expenses + Operating income Contribution margin ratio $210,000 + 0 0.60 $210,000 0.60 $350,000

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Graphing the CVP Relationships

Step 1:
Choose a sales volume (Units x $Price) Plot point for total sales revenue Draw sales revenue line from origin through the plotted point

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Preparing a CVP Chart

$20 000 $15 000

Dollars

$10 000 $5 000 $0 0 500 1 000 1 500 Volume of Units

Revenues

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Preparing a CVP Chart

Step 2: Draw the fixed cost line

$4,000

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Preparing a CVP Chart

Step 3: Draw the total cost line (fixed plus variable)
$20 000 $15 000 $10 000 $5 000 $0 0 500 1 000 1 500
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Revenues Fixed costs Total cost

Dollars

Volume of Units

Preparing a CVP Chart

Step 4: Identify the breakeven point and the areas of operating income and loss
$20 000 $15 000

Breakeven point

Dollars

$10 000 $5 000 $0 0 500 1 000 1 500 Volume of Units

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Preparing a CVP Chart

Step 5: Mark operating income and operating loss areas on graph
$20 000 $15 000

Breakeven point

Dollars

$10 000 $5 000 $0 0 500 1 000 1 500 Volume of Units

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CVP Chart for Bay Cruisline

Dollars (in thousands)
$700 000 $600 000 $500 000 $400 000 $300 000 $200 000 $100 000 $0 2 500 5 000 Tickets
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7 500

10000

CVP Chart for Bay Cruisline

Dollars (in thousands)
$700 000 $600 000 $500 000 $400 000 $300 000 $200 000 $100 000 $2 500 5 000 7 500 10000 Tickets
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Fixed Cost

CVP Chart for Bay Cruisline

Dollars (in thousands)
$700 000 $600 000 $500 000 $400 000 $300 000 $200 000 $100 000 $2 500 5 000 7 500 10000 Tickets
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Breakeven Point

Sensitivity Analysis
Managers need to be prepared for increasing costs, pricing pressure from competitors, and other changing business conditions. Sensitivity Analysis: Conducts What if analysis
What if the sales price changes? What if costs change? What if the sales mix changes?

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What if the Sales Price Changes?

Calculate a new unit contribution margin using the new sales price Use the new unit contribution margin to compute breakeven sales in units Use the new unit contribution margin to compute breakeven sales to maintain target profit Using the new breakeven numbers, decide if a change should be made
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What if Variable Cost Change?

Calculate a new unit contribution margin using the new cost Use the new unit contribution margin to compute breakeven sales in units Use the new unit contribution margin to compute breakeven sales to maintain target profit Using the new breakeven numbers, decide if a change should be made
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What if Fixed Costs Change?

Changes in fixed costs do not affect the contribution margin Breakeven point changes because fixed costs change Use the unit contribution margin to compute the new breakeven sales in units Use the unit contribution margin to compute breakeven sales to maintain target profit Using the new breakeven numbers, decide if a change should be made
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Operational Risk Indicators

Safety Margin Operating Leverage Safety Margin
Excess of expected sales over breakeven sales Drop in sales that the company can absorb before incurring a loss Used to evaluate the risk of current operations as well as the risk of new plans
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Calculating Safety Margin

Margin of safety Expected sales Breakeven = sales in units in units in units

Margin of safety = Expected sales in dollars

Breakeven sales

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Operating Leverage
The relevant amount of fixed and variable cost s that make up a companys total cost

How responsive a companys operating income is to changes in volume

Lowest possible value for this factor is 1, if the company has no fixed costs
Operating leverage factor

Operating Leverage Factor

= = =

Contribution margin Operating income $13,300 $6,300 2.11 (rounded)

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Operating leverage factor

High Operating Leverage

High operating leverage companies have:
Higher levels of fixed costs and lower levels of variable costs Higher contribution margin ratios

For high operating leverage companies, changes in volume significantly affect operating income, so they face:
Higher risk Higher potential for reward

Examples include golf courses, hotels, rental car agencies, theme parks, airlines, cruise lines

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Low Operating Leverage

Low operating leverage companies have:
Higher levels of variable costs and lower levels of fixed costs Lower contribution margin ratios

For low operating leverage companies, changes in volume do NOT have as significant an effect on operating income, so they face:
Lower risk Lower potential for reward

Examples include merchandising companies.

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