Cost-Volume-Profit Analyses

Learning Objectives
After studying this chapter, you should be able to:
[1] Distinguish between variable and fixed costs. [2] Explain the significance of the relevant range. [3] Explain the concept of mixed costs.

[4] List the five components of cost-volume-profit analysis.

[5] Indicate what contribution margin is and how it can be expressed. [6] Identify the three ways to determine the break-even point. [7] Give the formulas for determining sales required to earn target net income. [8] Define margin of safety, and give the formulas for computing it.

 Mixed costs contains both variable and fixed costs elements. What is the behaviour of mixed costs? Changes in total but not proportionately with changes in the level of activity. E.g. utility charge: Flat rate plus usage charge or rental

 Can we use mixed costs for CVP? Yes, but we must separate the fixed costs from the variable cost. How do we do that? By an analysis known as High-low method. Step 1: Variable cost/unit=change in TC/(H-L Activity Level) Step 2: Fixed cost= Total costs Total variable costs at either high/low activity level answer is the same. Equation : Mixed costs = Fixed costs (Step2) + Vc per unit (Step1)

Unit Selling Prices Level of Activity

Components of CVP

Variable cost per unit

Sales mix

Total fixed costs

Behavior of both costs and revenues is linear throughout the relevant range of the activity index. All costs can be classified as either variable or fixed with reasonable accuracy.

Changes in activity are the only factors that affect costs.

All units produced are sold. When more than one type of product is sold, the sales mix will remain constant.

 For internal use only Classifies costs as variable and expenses so as to show CM and then net income. Example below:

 Revenue remaining Contribution after deducting Margin variable costs

(CM)

Method

CM per unit= USPUVC CM ratio= CM per unit / USP

Net Income = Zero

Break Even Analysis

CM=Fixed Costs

Total costs=Total revenue

 1. Mathematical Equation: SP(x)= VC(x) +F C + NI : Net Income=Zero X= units: $$$= units x selling price(SP) 2. CM technique: Break even in units= FC + NI/ CM per unit Break even in dollars= FC + NI / CM ratio 3. Graphic Presentation page 217 5th edition

 What is it? Is a tool to help management understand how far sales could change before company start operating at a net loss. How do you calculate it: MOS in dollars= Actual(expected) sales- BE Sales MOS ratio= MOS in dollars / Actual (exp.) sales

The higher the sales dollars or percentages, the greater the MOS

 Learning Objectives

After studying this chapter, you should be able to:

[1] Describe the essential features of a cost-volume-profit income statement.

[2] Apply basic CVP concepts.

[3] Explain the term sales mix and its effects on break-even sales. [4] Determine sales mix when a company has limited resources. [5] Understand how operating leverage affects profitability.

 Sales mix is the relative proportion in which the company sells its products.

If a companys unit sales are 80% printers and 20% computers, its sales mix is 80% to 20%. Sales mix is important because different products often have very different contribution margins.

Breakeven in $$

Breakeven in Units

Looking at the Formula You are to gather two pieces of information: Step 1: Fixed Costs = Fixed costs of MOH +Fixed Costs Period expenses Step 2: Calculate Weighted Average Unit CM= ((USP-UVC prdA )x (Sales prdA/Total Sales) ) + ((USP-UVC prdB )x (Sales prdB /Total Sales)

 After you receive TOTAL Break-even point in Units THEN you calculate Break-even point in units per product. HOW? 1. Total Break-even units x Sales mix % Prd A= BEUnits Prd A 2. Total Break-even units x Sales mix %Prd B= BEUnits Prd B

The calculation of break-even point in units works well if the company has only a few products But what if there is a large quantity of products? When there are many products, calculate the breakeven point in terms of sales dollars for divisions or

product lines, NOT individual products.

 Step one: Fixed costs Step two: Calculate: Weighted-Average CM Ratio

Illustration 6-16

 Here we consider the Sales Dollars ($$$) CM Ratio = (Sales Dollars- V. costs Dollars) / Sales Dollars Sales Mix Percentage: Total Sales Revenue Dollars / Prdx Sales Revenue Relationship between products and Net Income? Greater if more higher-contribution margin units are sold than lower-contribution margin units.

Illustration 6-16

 All companies have limited resources whether it be floor space, raw materials, direct labor hours, etc.

Limited resources force management to decide which products to sell to maximize net income. To determine the appropriate sales mix, compute the contribution margin per unit of limited resource:

Product with the higher CM per unit of Limited resource will be the product managemt should produce more of.

 What is Cost structure? Cost Structure is the relative proportion of fixed versus variable costs that a company incurs. Why is it important? 1. It has an Effect on CM Ratio

It has an Effect on Break-even point in Dollars

 What is Operating leverage? It refers to the extent that net income reacts to a given change in sales. What is the effect on income levels?

Higher fixed costs relative to variable costs cause a company to have higher operating leverage.

When sales revenues are increasing, high operating leverage means that profits will increase rapidly a good thing.
When sales revenues are declining, too much operating leverage can have devastating consequences.

Illustration 6-25

New Waves earnings would go up (or down) by about two times (5.33 2.67 = 1.99) as much as Vargos with an equal increase in sales.

 Announcement: MST details are on Moodle. TUESDAY 23/04/2013 at 4pm Fiji time Venue: Contact your respective SAS at the earliest. Assignment due Tuesday April 9th 2013.