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Management Accounting 3

Break-even Analysis

Chapter 8: Cost-Volume-Profit Analysis


(Drury)

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Cost-volume Profit Analysis

Introduction
• Break-even sales when Profit = 0
• How many units sales to break-even?
• What sales volume needed to meet
additional Fixed Costs?
• Pay sales people fixed salary or
commission or mix?

Answer can be provided using Cost-


Volume-Profit (CVP) Analysis.
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Cost-volume Profit Analysis

Cost-Volume-Profit (CVP) Analysis


• A systematic method of examining the relationship
between changes in activity (output) and changes in
total sales revenue, expenses, & net profit.
• Simplify real world conditions facing a firm.
• Subject to underlying assumptions & limitation.
• A powerful tool for decision-making in certain situations.
• Objectives:
 Effects on financial result if activity or volume fluctuates
 Important as output/volume is one of the most important
variables influencing sales revenue, total costs, &
profits.

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Key Assumptions of CVP Analysis

1. All other variables remain constant


2. Single product or constant sales mix
3. Total costs and sales are linear functions of
output
4. Profits are calculated on variable/marginal
costing basis
5. Analysis applies to relevant range only
6. Analysis applies only to a short-term time
horizon
7. Costs can be accurately divided into fixed and
variable elements
8. Complexity-related fixed costs do not change
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Cost-volume Profit Analysis

Cost-Volume-Profit (CVP) Analysis


• Output is given special attention – relationship study will
identify critical output levels (the BE point).
• Analysis good in the short-run:
 Less than 1 year
 Restricted by current operating capacity
 Operate on relatively constant production level
 Most costs and expenses are fixed except sales
volume
 Profitability most sensitive to sales volume
 CVP highlights effects of changes in sales
volume on profit
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Basics of Cost-Volume-Profit Analysis

Contribution Margin (CM) is the amount


remaining from sales revenue after variable
expenses have been deducted.
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Basics of Cost-Volume-Profit Analysis

CM is used first to cover fixed


expenses. Any remaining CM
contributes to net operating income.
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The Contribution Approach

Sales, variable expenses, and contribution margin can


also be expressed on a per unit basis. If Racing sells
an additional bicycle, $200 additional CM will be
generated to cover fixed expenses and profit.

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The Contribution Approach

Each month Racing must generate at least


$80,000 in total CM to break even.

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The Contribution Approach

If Racing sells 400 units in a month, it will be


operating at the break-even point.

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The Contribution Approach

If Racing sells one more bike (401 bikes), net


operating income will increase by $200.

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The Contribution Approach

Profits at a particular sales volume can be


estimated by:
Number of units sold above break-even X the
contribution margin per unit.

If Racing sells 430


bikes, its profit will
be $6,000
(30x$200)

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CVP Relationships in Graphic Form

The relationship among revenue, cost, profit and


volume can be expressed graphically by preparing
a CVP graph. Racing developed contribution
margin income statements at 300, 400, and 500
units sold. We will use this information to prepare
the CVP graph.

Income Income Income


300 units 400 units 500 units
Sales $ 150,000 $ 200,000 $ 250,000
Less: variable expenses 90,000 120,000 150,000
Contribution margin $ 60,000 $ 80,000 $ 100,000
Less: fixed expenses 80,000 80,000 80,000
Net operating income $ (20,000) $ - $ 20,000

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CVP Graph

450,000

400,000

350,000

300,000

250,000

200,000
In a CVP graph, unit volume is
150,000
usually represented on the
100,000
horizontal (X) axis and dollars on
50,000
the vertical (Y) axis.
-
- 100 200 300 400 500 600 700 800

Units

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CVP Graph

450,000

400,000

350,000

300,000

250,000

200,000

150,000 Fixed Expenses


100,000

50,000

-
- 100 200 300 400 500 600 700 800

Units

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CVP Graph

450,000

400,000

350,000

300,000

250,000
Total Expenses
200,000

150,000 Fixed Expenses


100,000

50,000

-
- 100 200 300 400 500 600 700 800

Units

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CVP Graph

450,000

400,000

350,000 Total Sales


300,000

250,000
Total Expenses
200,000

150,000 Fixed Expenses


100,000

50,000

-
- 100 200 300 400 500 600 700 800

Units

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CVP Graph

450,000

400,000
Break-even point
(400 units or $200,000 in sales)
350,000

300,000

250,000

200,000

150,000

100,000

50,000

-
- 100 200 300 400 500 600 700 800

Units

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Break-Even Analysis

Break-even analysis can be


approached in two ways:
1. Equation method
2. Contribution margin method

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Equation Method

Net Profits = Sales – (Variable costs + Total Fixed costs)

OR

Net Profits = (unit sold x unit selling price) –

[(unit sold x unit variable cost) - Total Fixed costs]

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Break-Even Analysis
Example 8.1(pg 271 Drury)
Concert viability
Fixed Costs = $60,000
Variable = $10 per ticket sold
Selling price = $20 per ticket
Output = 5000 units

1. No. of ticket sales to break even


Net Profits = (unit sold x unit selling price) –
(unit sold x unit variable cost) - Total Fixed costs

0 = (Tx20) – (Tx10) - 60,000


(Tx10) = 60,000
T = 60,000/10
T = 6,000 tickets

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Break-Even Analysis
Example 8.1(pg 271 Drury)
Concert viability
Fixed Costs = $60,000
Variable = $10 per ticket sold
Selling price = $20 per ticket

1. No. of ticket sales to break even - CM method:


CM per unit = (20 – 10)/T = $10
Total Contribution = 10T
BE when Total Contribution = Total Fixed Costs
10T = $60,000
T = 60,000 / 10
T = 6,000 tickets

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Break-Even Analysis
Example 8.1(pg 271 Drury)
Concert viability
Fixed Costs = $60,000
Variable = $10 per ticket sold
Selling price = $20 per ticket

2. No. of ticket sales to earn target profit of $30,000


Net Profits = (unit sold x unit selling price) –
(unit sold x unit variable cost) - Total Fixed costs

30,000 = (Tx20) – (Tx10) - 60,000


(Tx10) = 60,000 + 30,000
T = 90,000/10
T = 9,000 tickets

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Break-Even Analysis
Example 8.1(pg 271 Drury)
Concert viability
Fixed Costs = $60,000
Variable = $10 per ticket sold
Selling price = $20 per ticket

2. No. of ticket sales to earn target profit of $30,000 - CM method:


CM per unit = (20 – 10)/T = $10
Total Contribution = 10T
Total Contribution needed = Total Fixed Costs + target profit
10T = $60,000 + $30,000
T = 90,000 / 10
T = 9,000 tickets

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Break-Even Analysis
Example 8.1(pg 271 Drury)
Concert viability
Fixed Costs = $60,000
Variable = $10 per ticket sold
Selling price = $20 per ticket

3. What profit if No. of ticket sales = 8,000


Net Profits = (unit sold x unit selling price) –
(unit sold x unit variable cost) - Total Fixed costs

P = (Tx20) – (Tx10) - 60,000


P = (8,000x10) - 60,000
P = 80,000 – 60,000
P = $20,000

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Break-Even Analysis
Example 8.1(pg 271 Drury)
Concert viability
Fixed Costs = $60,000
Variable = $10 per ticket sold
Selling price = $20 per ticket

4. What selling price per ticket to produce profit of $30,000 and ticket
sales at 8,000
Net Profits = (unit sold x unit selling price) –
(unit sold x unit variable cost) - Total Fixed costs

$30,000 = (8,000xS) – (8,000x10) - 60,000


30,000 = (8,000xS) – 80,000 - 60,000
8,000S = 140,000 + 30,000
S = $170,000 / 8,000 = $21.25 per ticket

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Break-Even Analysis
Example 8.1(pg 271 Drury)
Concert viability
Fixed Costs = $60,000
Variable = $10 per ticket sold
Selling price = $20 per ticket

5. Additional tickets needed to cover extra Fixed costs of $8,000


Net Profits = (unit sold x unit selling price) –
(unit sold x unit variable cost) - Total Fixed costs

P = (Tx20) – (Tx10) - 60,000 + 8,000


P = 10T - 68,000
T = 68,000 / 10
T = 6,800
Extra ticket = 6,800 – 6,000 = 800

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Contribution Margin Ratio

The contribution margin ratio is:


Total CM @ BE
CM Ratio =
Total sales @ BE
For Racing Bicycle Company the ratio is:
@ BE, CM = $80,000
Sales = $200,000
$80,000
= 40%
$200,000
Each $1.00 increase in sales results in a
total contribution margin increase of 40¢.

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Contribution Margin Ratio

Or, in terms of units, the contribution margin ratio is:


Unit CM
CM Ratio =
Unit selling price
For Racing Bicycle Company the ratio is:

$200 = 40%
$500

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Contribution Margin Ratio

400 Bikes 500 Bikes


Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income $ - $ 20,000

A $50,000 increase in sales revenue


results in a $20,000 increase in CM.
($50,000 × 40% = $20,000)

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Quick Check 

Coffee Klatch is an espresso stand in a


downtown office building. The average selling price
of a cup of coffee is $1.49 and the average variable
expense per cup is $0.36. The average fixed
expense per month is $1,300. 2,100 cups are sold
each month on average. What is the CM Ratio for
Coffee Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139

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Quick Check 

Coffee Klatch is an espresso stand in a


downtown office building. The average selling price
of a cup of coffee is $1.49 and the average variable
expense per cup is $0.36. The average fixed
expense per month is $1,300. 2,100 cups are sold
each month on average. What is the CM Ratio for
Coffee Klatch? Unit contribution margin
CM Ratio =
a. 1.319 Unit selling price
b. 0.758 ($1.49-$0.36)
=
c. 0.242 $1.49
d. 4.139 $1.13
= = 0.758
$1.49
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Changes in Fixed Costs and Sales Volume

What is the profit impact if Racing can


increase unit sales from 500 to 540
by increasing the monthly advertising
budget by $10,000?

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Changes in Fixed Costs and Sales Volume
$80,000 + $10,000 advertising = $90,000

Sales increased by $20,000, but net operating


income decreased by $2,000.
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Changes in Fixed Costs and Sales Volume

The Shortcut Solution


Increase in CM (40 units X $200) $ 8,000
Increase in advertising expenses 10,000
Decrease in net operating income $ (2,000)

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Separation of semi-variable costs: The High-
Low Method

Assume the following hours of maintenance work and


the total maintenance costs for six months.

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Separation of semi-variable costs: The High-
Low Method

The variable cost


per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.

$2,400
= $8.00/hour
300

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Separation of semi-variable costs: The High-
Low Method

Total Fixed Cost = Total Cost – Total Variable Cost


Total Fixed Cost = $9,800 – ($8/hour × 800 hours)
Total Fixed Cost = $9,800 – $6,400
Total Fixed Cost = $3,400
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Quick Check 

Sales salaries and commissions are $10,000 when


80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is
the variable portion of sales salaries and
commission?
a. $0.08 per unit
b. $0.10 per unit
c. $0.12 per unit
d. $0.125 per unit

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Quick Check 

Sales salaries and commissions are $10,000 when


80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is
the variable portion of sales salaries and
commission?
Units Cost
a. $0.08 per unit High level 120,000 $ 14,000
b. $0.10 per unit Low level 80,000 10,000
c. $0.12 per unit Change 40,000 $ 4,000

d. $0.125 per unit $4,000 ÷ 40,000 units


= $0.10 per unit

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Quick Check 

Sales salaries and commissions are $10,000 when


80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is
the fixed portion of sales salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000

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Quick Check 

Sales salaries and commissions are $10,000 when


80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is
the fixed portion of sales salaries and commissions?
a. $ 2,000 Total cost = Total fixed cost +
Total variable cost
b. $ 4,000
$14,000 = Total fixed cost +
c. $10,000 ($0.10 × 120,000 units)
d. $12,000 Total fixed cost = $14,000 - $12,000
Total fixed cost = $2,000

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Learning Objective 7

Explain the effects of sales


mix on profits.

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Effects of Sales Mix
on Income
• Sales mix is the combination of products
that a business sells.

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Effects of Sales Mix
on Income

Avisha’s Dresses Example

Selling price: $90


Less variable cost: 32
Equals contribution margin per dress: $58

Fixed costs = $96,000

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Effects of Sales Mix
on Income
Assume that Avisha is considering selling
blouses. This will not require any additional
fixed costs.
• She expects to sell 2 blouses at $30 each for
every dress she sells.
• The variable cost per blouse is $19.
• What is the new breakeven point?

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Effects of Sales Mix
on Income-method 1

Contribution margin per blouse: $30 – $19 = $11

What is the contribution margin of the mix?

$58 + (2 × $11) =
$58 + $22 = $80

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Effects of Sales Mix
on Income

$96,000 fixed costs ÷ $80 = 1,200 packages

1,200 × 2 = 2,400 blouses


1,200 × 1 = 1,200 dresses
Total units = 3,600

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Effects of Sales Mix
on Income

What is the breakeven in dollars?

2,400 blouses × $30 = $ 72,000


1,200 dresses × $90 = 108,000
$180,000

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Effects of Sales Mix
on Income-Method 2

What is the weighted-average


budgeted
contribution margin?

Dresses: 1 × $58 + Blouses: 2 × $11

= $80 ÷ 3 = $26.67
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Effects of Sales Mix
on Income

The break even point for the two products is:


$96,000 ÷ $26.667 = 3,600 units

3,600 × 1/3 = 1,200 dresses


3,600 × 2/3 = 2,400 blouses

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Effects of Sales Mix
on Income

Sales mix can be stated in sales dollars:


Dresses Blouses
Sales price $90 $60
Variable costs 32 38
Contribution margin $58 $22
Contribution margin ratio 64.4% 36.6%

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Effects of Sales Mix
on Income

Assume the sales mix in dollars is 60%


dresses and 40% blouses.

Weighted contribution would be:


64.4% × 60% = 38.64% dresses
36.6% × 40% = 14.64% blouses
53.28%

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Effects of Sales Mix
on Income

Break even sales dollars is $96,000 ÷ 53.28%


= $180,000 (rounding)

$180,000 × 60% = $108,000 dress sales


$180,000 × 40% = $ 72,000 blouse sales

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Learning Objective 8

Compute cost-volume-
profit relationships on an
after-tax basis.

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Target Net Income and Income Taxes

Management of Avisha’s Dresses would like


to earn an after-tax income of $35,721.
• The tax rate is 30%.
• What is the target operating income [TOI]?
TOI = Target net income ÷ (1 – tax rate)
TOI = $35,721 ÷ (1 – 0.30)
TOI = $51,030

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Target Net Income and Income Taxes

• How many units must she sell?


• Revenues – Variable costs – Fixed costs =
Target net income ÷ (1 – tax rate)
• $90Q – $32Q – $96,000 = $35,721 ÷ 0.70
• $58Q = $51,030 + $96,000
• Q = $147,030 ÷ $58
• Q = 2,535 dresses

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Target Net Income and Income Taxes

Revenues (2,535 × $90) $228,150


Variable costs (2,535 × $32) 81,120
Contribution margin: $147,030
Fixed costs: 96,000
Operating income: $ 51,030
Income taxes: ($51,030 × .30) 15,309
Net income $ 35,721

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Revision Question

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End of Chapter 8

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