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# Management Accounting 3

Break-even Analysis

## Chapter 8: Cost-Volume-Profit Analysis

(Drury)

Cost-volume Profit Analysis

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

## Answer can be provided using Cost-

Volume-Profit (CVP) Analysis.
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.

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
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
Basics of Cost-Volume-Profit Analysis

## Contribution Margin (CM) is the amount

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

## CM is used first to cover fixed

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

## Sales, variable expenses, and contribution margin can

also be expressed on a per unit basis. If Racing sells
generated to cover fixed expenses and profit.

The Contribution Approach

## Each month Racing must generate at least

\$80,000 in total CM to break even.

The Contribution Approach

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

operating at the break-even point.

The Contribution Approach

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

operating income will increase by \$200.

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)

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

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

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

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

CVP Graph

450,000

400,000

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

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

Break-Even Analysis

## Break-even analysis can be

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

Equation Method

OR

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

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

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

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

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

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

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

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

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¢.

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

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)

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

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
Changes in Fixed Costs and Sales Volume

## What is the profit impact if Racing can

increase unit sales from 500 to 540
budget by \$10,000?

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.
Changes in Fixed Costs and Sales Volume

## The Shortcut Solution

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

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

## Assume the following hours of maintenance work and

the total maintenance costs for six months.

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

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
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

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

= \$0.10 per unit

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

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

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

12
Effects of Sales Mix
on Income

## 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

## What is the contribution margin of the mix?

\$58 + (2 × \$11) =
\$58 + \$22 = \$80

12
Effects of Sales Mix
on Income

## 1,200 × 2 = 2,400 blouses

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

12
Effects of Sales Mix
on Income

## 2,400 blouses × \$30 = \$ 72,000

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

12
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
12
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

12
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%

12
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%

12
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.

12
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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