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Cost-Volume-Profit Relationships

Break Even Analysis


Costs/Revenue TR TR TC VC

The break even point occurs where total revenue equals total costs the firm, in this example, would have to TheQ1 to costsprice, sell lower the The total generate therefore (assuming sufficient revenue the less steep the to accurate costs. cost) cover its fixed total revenue curve. Total revenue is determined by the price charged and the quantity sold again this will be determined by expected forecast sales initially.

FC

Q1

Output/Sales

Break Even Analysis


Costs/Revenue
TR (p = $3) TR (p = $2)

TC VC

If the firm chose to set price higher than $2 (say $3) the TR curve would be steeper they would not have to sell as many units to break even

FC

Q2

Q1

Output/Sales

Break Even Analysis


Costs/Revenue
TR (p = $1) TR (p = $2)

TC

VC

If the firm chose to set prices lower (say $1) it would need to sell more units before covering its costs.

FC

Q1

Q3

Output/Sales

Break Even Analysis


Costs/Revenue
TR (p = $2)

TC VC

Profit

Loss FC

Q1

Output/Sales

Break Even Analysis


Costs/Revenue
TR (p = $3) TR (p = $2)

TC VC

Margin of safety shows how far sales can fall before losses made. If Q1 = 1000 and Q2 = 1800, sales Assume current could fall by 800 sales at Q2. units before a loss would be made.

Margin of Safety

A higher price would lower the break even point and the margin of safety would widen.

FC

Q3

Q1

Q2

Output/Sales

High initial FC. Interest on debt rises each year FC rise therefore.

Costs/Revenue FC 1

FC
Losses get bigger!

TR VC

Output/Sales

The Basics of Cost-Volume-Profit (CVP) Analysis


WIND BICYCLE CO. Contribution Income Statement For the Month of June Total Per Unit Sales (500 bikes) $ 250,000 $ 500 Less: variable expenses 150,000 300 Contribution margin 100,000 $ 200 Less: fixed expenses 80,000 Net income $ 20,000

After covering fixed costs, any remaining CM contributes to income.

The Contribution Approach


For each additional unit Wind sells, $200 more in contribution margin will help to cover fixed expenses and profit.
Sales (500 bikes) Less: variable expenses Contribution margin Less: fixed expenses Net income Total $250,000 150,000 $100,000 80,000 $ 20,000 Per Unit $ 500 300 $ 200

Perc 1

The Contribution Approach


Each month Wind must generate at least $80,000 in total CM to break even.
Total $250,000 150,000 $100,000 80,000 $ 20,000 Per Unit $ 500 300 $ 200

Sales (500 bikes) Less: variable expenses Contribution margin Less: fixed expenses Net income

Perc 1

The Contribution Approach


If Wind sells 400 units in a month, it will be operating at the break-even point.
WIND BICYCLE CO. Contribution Income Statement For the Month of June Total Per Sales (400 bikes) $ 200,000 $ Less: variable expenses 120,000 Contribution margin 80,000 $ Less: fixed expenses 80,000 Net income $ 0

Unit 500 300 200

The Contribution Approach


If Wind sells one additional unit (401 bikes), net income will increase by $200.
WIND BICYCLE CO. Contribution Income Statement For the Month of June Total Per Unit Sales (401 bikes) $ 200,500 $ 500 Less: variable expenses 120,300 300 Contribution margin 80,200 $ 200 Less: fixed expenses 80,000 Net income $ 200

The Contribution Approach


The break-even point can be defined either as:
The point where total sales revenue equals total expenses (variable and fixed). The point where total contribution margin equals total fixed expenses.

CVP Relationships in Graphic Form


Viewing CVP relationships in a graph gives managers a perspective that can be obtained in no other way. Consider the following information for Wind Co.:
Income 300 units $ 150,000 90,000 $ 60,000 80,000 $ (20,000) Income 400 units $ 200,000 120,000 $ 80,000 80,000 $ Income 500 units $250,000 150,000 $100,000 80,000 $ 20,000

Sales Less: variable expenses Contribution margin Less: fixed expenses Net income (loss)

Contribution Margin Ratio


The contribution margin ratio is:
CM Ratio = Contribution margin Sales

For Wind Bicycle Co. the ratio is:


$200 $500 = 40%

Contribution Margin Ratio

At Wind, each $1.00 increase in sales revenue results in a total contribution margin increase of 40.
If sales increase by $50,000, what will be the increase in total contribution margin?

Contribution Margin Ratio


Sales Less: variable expenses Contribution margin Less: fixed expenses Net income 400 Bikes $200,000 120,000 80,000 80,000 $ 500 Bikes $250,000 150,000 100,000 80,000 $ 20,000

A $50,000 increase in sales revenue

Contribution Margin Ratio


Sales Less: variable expenses Contribution margin Less: fixed expenses Net income 400 Bikes $200,000 120,000 80,000 80,000 $ 500 Bikes $250,000 150,000 100,000 80,000 $ 20,000

A $50,000 increase in sales revenue results in a $20,000 increase in CM or ($50,000 40% = $20,000)

Changes in Fixed Costs and Sales Volume


Wind is currently selling 500 bikes per month. The companys sales manager believes that an increase of $10,000 in the monthly advertising budget would increase bike sales to 540 units. Should we authorize the requested increase in the advertising budget?

Changes in Fixed Costs and Sales Volume


$80,000 + $10,000 advertising = $90,000
Current Sales (500 bikes) Sales $ 250,000 Less: variable expenses 150,000 Contribution margin 100,000 Less: fixed expenses 80,000 Net income $ 20,000 Projected Sales (540 bikes) $ 270,000 162,000 108,000 90,000 $ 18,000

Sales increased by $20,000, but net income decreased by $2,000.

Changes in Fixed Costs and Sales Volume


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

APPLICATIONS OF CVP
Consider the following basic data:
Sales Price Less: Variable cost Contribution margin

Per unit $250 150 100

Percent 100 60 40

Fixed costs total $35,000

Change in Fixed Cost and Sales Volume


Current sales are $100,000. Sales manager

feels $10,000 increase in sales budget will provide $30,000 increase in sales. Should the budget be changed?
YES

Incremental CM approach: $30,000 x 40% CM ratio Additional advertising expense Increase in net income

$12,000 10,000 $2,000

Change in Variable Cost and Sales Volume


Management is considering increasing quality of

speakers at an additional cost of $10 per speaker and plan to sell 80 more units. Should management increase quality?
YES

Expected total CM = (480 speakers x $90) Present total CM = (400 speakers x $100) Increase in total contribution margin (and net income)

$43,200 40,000 $3,200

Change in Fixed Cost, Sales Price and Sales Volume


Management advises that if selling price dropped $20

per speaker and advertising increased by $15,000/month, sales would increase 50%. Good idea? Expected total CM = (400 x 150% x $80) Present total CM (400 x $100) Incremental CM Additional advertising cost Reduction in net income NO

$48,000 40,000 8,000 15,000 $(7,000)

Change in Variable Cost, Fixed Cost, n Sales Volume

A plan to switch salespeople from flat salary ($6,000

per month) to a sales commission of $15 per speaker could increase sales by 15%. Good idea?
YES Expected total CM (400x115%x$85) Current total CM (400 x $100) Decrease in total CM Salaries avoided if commission paid Increase in net income $39,100 40,000 (900) 6,000 $5,100

Change in Regular Sales Price


A wholesaler is willing to buy 150 speakers if we will

give him a discount off our price. The sale will not disturb regular sales and will not change fixed costs. We want to make $3,000 on this sale. What price should we quote?
Variable cost per speaker Desired profit on order (3,000/150) Quoted price per speaker $150 20 $170

Break-Even Analysis
Break-even analysis can be approached in two ways: Equation method Contribution margin method.

Equation Method
Profits = Sales (Variable expenses + Fixed expenses) OR Sales = Variable expenses + Fixed expenses + Profits

At the break-even point profits equal zero.

Equation Method
Here is the information from Wind Bicycle Co.:
Total $250,000 150,000 $100,000 80,000 $ 20,000 Per Unit $ 500 300 $ 200 Percent 100% 60% 40%

Sales (500 bikes) Less: variable expenses Contribution margin Less: fixed expenses Net income

Equation Method
We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $0 $200Q = $80,000 Q = 400 bikes


Where: Q $500 $300 $80,000

= Number of bikes sold = Unit sales price = Unit variable expenses = Total fixed expenses

Equation Method
We can also use the following equation to compute the break-even point in sales dollars. Sales = Variable expenses + Fixed expenses + Profits

X = 0.60X + $80,000 + $0 0.40X = $80,000 X = $200,000


Where:
X = Total sales dollars 0.60 = Variable expenses as a percentage of sales $80,000 = Total fixed expenses

Contribution Margin Method


The contribution margin method is a variation of the equation method.

Break-even point = in units sold

Fixed expenses Unit contribution margin

Break-even point in total sales dollars =

Fixed expenses CM ratio

Target Profit Analysis


Suppose Wind Co. wants to know how many bikes must be sold to earn a profit of $100,000. We can use our CVP formula to determine the sales volume needed to achieve a target net profit figure.

The CVP Equation


Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $100,000 $200Q = $180,000 Q = 900 bikes

The Contribution Margin Approach


We can determine the number of bikes that must be sold to earn a profit of $100,000 using the contribution margin approach.
Units sold to attain = the target profit Fixed expenses + Target profit Unit contribution margin

$80,000 + $100,000 $200

= 900 bikes

The Margin of Safety


Excess of budgeted (or actual) sales over the break-even volume of sales. The amount by which sales can drop before losses begin to be incurred.
Margin of safety = Total sales - Break-even sales

Lets calculate the margin of safety for Wind.

The Margin of Safety


Wind has a break-even point of $200,000. If actual sales are $250,000, the margin of safety is $50,000 or 100 bikes.
Break-even sales 400 units Sales $ 200,000 Less: variable expenses 120,000 Contribution margin 80,000 Less: fixed expenses 80,000 Net income $ Actual sales 500 units $ 250,000 150,000 100,000 80,000 $ 20,000

The Margin of Safety


The margin of safety can be expressed as 20 percent of sales. ($50,000 $250,000)
Break-even sales 400 units Sales $ 200,000 Less: variable expenses 120,000 Contribution margin 80,000 Less: fixed expenses 80,000 Net income $ Actual sales 500 units $ 250,000 150,000 100,000 80,000 $ 20,000