Req. 3 Operating leverage factor at target level of operating income?Req. 4 If sales volume declines by 9%, what percentage will operating income decline?Chapter 7 – Cost-Volume-Profit Analysis7.1Cost-Volume-Profit Analysis (CVP)• Powerful tool that helps managers make important business decisions• Relies on the interdependency of five components of information1) Sales price per units2) Volume sold3) VE per unit4) Fixed Expenses5) Operating Income (profit or loss)• If you know or can estimate four of these five components, you can compute the remaining unknown amountAssumptions Underlying CVP AnalysisManagers must be aware of these when using CVP:1. Change in volume is only factor that affects costs2. Managers can classify each cost as either variable or fixed.• These costs are linear throughout relevant range3. Revenues are linear throughout relevant range4. Inventory levels will NOT change5. The sales mix of products will NOT change• Combination of products that make up total salesContribution Format Income Statement and Contribution Margin Per UnitContribution Margin per Unit = Selling Price per unit – VE per unitOr = Total Contribution Margin / # of unitsTotal SalesTotal Variable CostsOnce a company’s contribution margin covers its fixed costs, each additional unit soldincreases profit by the amount of the unit contribution marginNow assume sales are 2,500 units. What would operating income be?Contribution Margin Less Fixed CostsOperating IncomeOr Original Operating Income + ( Additional units x CM per unit)Contribution Margin Ratio (CMR)• Percentage of each sales dollar that is available for covering fixed expenses and generating aprofit • CMR is particularly useful when unit information is not available or a company has multiple products. Contribution Margin Ratio = Total CM / Total SalesOr = CM per unit / SP per unitUsing the information from our previous examples, contribution margin ratio andvariable expenses can be expressed as a percent of sales:How many units did the company sell? What would net income be if the companysold one more unit?more unit at $50 per unit?Contribution margin per unit is the selling price of one unit minus the variable cost per unitIf sales increase $1,000, how much will operating income increase? $40,000 or $20 $100,000 $50Notice that the Contribution Margin Ratio and the Variable Expense ratio must = 100%.Consequently, if you know the one of the ratios, you automatically know the other.If sales are $125,000, what would operating income be?Contribution Margin Less Fixed CostsOperating IncomeLuxury Cruiseline offers nightly cruises off the cost of Miami, San Francisco, and Seattle and expects the following: Ticket price per passenger $120Variable cost per passenger $48Monthly fixed costs of operating vessels, (depreciation, salaries, docking fees, and other)$270,000 The company’s relevant range extends to 15,000 monthly passengers.a. Contribution margin per passenger is b. Contribution margin ratio isc. Using unit contribution margin, if monthly sales total 10,000 passenger tickets, operating income will be d. Using the contribution margin ratio, if monthly sales are $650,000, operating income will be7.2Breakeven Point• Sales level at which operating income is zero .o If sales are above breakeven , profit resultso If sales are below breakeven, loss results• Fixed Expenses = Total Contribution Margin• Total sales = Total ExpensesTHREE METHODS:- Income Statement ApproachThe contribution margin income statement can be expressed as an equation as follows:(Where X is units sold):Let’s check our answer:Sales Less Variable Expenses Contribution MarginLess Fixed ExpensesOperating IncomeAnderson Dry Cleaners has determined the following about its costs: Total variable costs at the current level of sales are $42,000, total fixed costs are $24,000, and the sales needed to breakeven are $48,000.Determine the company’s 1) current sales revenue and 2) current operating income.At Breakeven Point,Operating Income (Profit) = 0 ( $50 x X ) - ( $30 x X ) - $30,000 = 0 $20 X - $30,000 = 0 $20 X = $30,000 X = $30,000 / $20 X =At BE:Sales Less Variable Expenses Contribution MarginLess Fixed ExpensesOperating Income2 Shortcut Approaches Using:- Unit Contribution Margino Answer is in units (Where X is units sold):Back to our example:Breakeven Units (X) = Note: Using the Income Statement Approach, our final calculation wasFixed Expenses / CM per Unit Healthy Greetings Corporation produces and sells fruit baskets for special events. The unit selling price is $60, unit variable costs are $45, and total fixed costs are $2,670. Determine the unit contribution margin.Sales – Variable Expenses – Fixed Expenses = Operating IncomeContribution Margin – Fixed Expenses = Operating Income(CM per unit x X) = Fixed Expenses + Operating IncomeX = Fixed Expenses + Operating Income CM per Unit When Operating Income = 0, X is the Breakeven Point in unitsDetermine the number of fruit baskets that must be sold to breakeven.- Contribution Margin Ratioo Answer is in sales dollars ($)o Useful for multi-product companies Sales in Dollars ($) = Fixed Expenses + Operating Income Contribution Margin RatioBack to our example: Breakeven in $ =Anthony Office Supplies sells refills on printer ink cartridges for $16 per refill. Variable costs are $4 per refill. Fixed costs are $2,000 per month. What is the contribution margin ratio for the printer ink cartridge refills?What is the breakeven point in sales dollars?Target Profit- The three formulas used above can also be used to determine the level of sales needed to achieve any desired (target) profito Instead of “0” for “Operating Income”, use the target profit.o Unit Contribution Margin formula will yield the answer in units .o Contribution Margin Ratio will yield the answer in sales dollar.Back to our