Chapter 5 Cost Volume Profit Relationships Cost volume profit CVP analysis is a powerful tool that helps managers understand the relationships among cost volume and profit focuses on how profits are affected by selling prices sales volume unit variable costs total fixed costs mix of products sold The Basics of Cost Volume Profit CVP Analysis Contribution income statement emphasizes the behavior of costs and therefore is extremely helpful to managers in judging the impact on profits of changes in selling price cost or volume o Sales variable expenses contribution margin fixed expenses net operating income o Profit sales variable expenses fixed expenses Sales P Q Variable expenses V Q Same equation in another way P Q V Q fixed expenses o Unit contribution margin selling price per unit variable expenses per unit Profit unit CM Q fixed expenses Contribution margin sales variable expenses amount available to cover fixed expenses and then to provide profits Break even point level in sales at which profit is zero no profit no loss just cover all of its costs o Once the break even point has been reached net operating income will increase by the amount of the unit contribution margin for each additional unit sold o To estimate profit at any sales volume above the break even point number of units sold in excess of break even point unit contribution margin o To estimate the effect of a planned increase in sales on profits increase in units sold unit contribution margin If sales 0 the company s loss its fixed expenses Each unit that is sold reduces the loss by the amount of the unit contribution Cost volume profit CVP graph highlights CVP relationships over wide margin ranges of activity o Unit volume horizontal X o Dollars vertical Y o 1 Draw a line parallel to the X axis to represent total fixed expenses o 2 Choose some volume of unit sales and plot the point representing total expense at this sales volume o 3 Choose some volume of sales and plot the point representing total sales dollars at this sales volume o Break even total revenue line total expense line Sales below break even point suffers a loss Contribution margin ratio CM ratio contribution margin as a percentage of sales shows how the contribution margin will be affected by a change in total sales o CM ratio contribution margin sales o CM ratio on a per unit basis CM ratio unit contribution margin unit selling price o Change in contribution margin CM ratio change in sales o Profit CM ratio sales fixed expenses Variable expense ratio variable expenses sales Lets relate the CM ratio and the variable expense ratio o CM ratio contribution margin sales o CM ratio sales variable expenses sales o CM ratio 1 variable expense ratio Incremental analysis simple more direct focuses attention on the specific changes that would occur o Incremental contribution margin went from 60 000 to 72 000 12 000 o Minus incremental advertising expense 10 000 o increased net operating income 2 000 What price per speaker should be quoted to the wholesaler if Amazon is seeking a profit of 3 000 o Variable cost per speaker 150 o Desired profit per speaker 3 000 150 20 o 150 20 170 Target Profit and Break Even Analysis Target profit analysis we estimate what sales volume is needed to achieve a specific target point o How can units do we need to sell Equation method profit unit CM Q fixed expenses Formula method unit sales to attain the target profit target profit fixed expenses unit CM o How many dollar sales are needed to attain the target profit Use equation method or formula method to find the unit sales needed then multiple it by the selling price OR profit CM ratio sales fixed expenses OR dollar sales to attain a target profit target profit fixed expenses CM ratio Unit sales to break even fixed expenses unit CM o OR you can just plug in zero to the target profit in the above equations Dollar sales to break even fixed expenses CM ratio o OR Solve for break even point using the equation or formula method above then multiple by selling price Margin of safety is the excess of budgeted or actual sales dollars over the break even volume of sales dollars o Margin of safety in dollars total budgeted or actual sales break even sales o Can be expressed in the number of units sold margin of safety in dollars selling price per unit CVP Considerations in Choosing a Cost Structure Cost structure refers to the relative proportion of fixed and variable costs Higher CM ratio will lead to higher net operating income if sales increase Operating leverage is a measure of how sensitive net operating income is Lower CM ratio will not loose its margin as fast when sales decline to a given percentage change in dollar sales Degree of operating leverage contribution margin net operating income o A measure at a given level of sales of how a percentage change in sales Percentage change in net operating income degree of operating leverage volume will affect profits percentage change in sales Higher proportion of fixed costs higher operating leverage The degree of operating leverage is not a constant it is greatest at sales levels near the break even point and decreases as sales and profits rise If a company is near its break even point small percentage increases in sales can yield large percentage increases in profits Structuring Sales Commissions Commissions based on sales dollars can lead to lower profits Commissions should be based on contribution margins instead Sales Mix Sales mix refers to the relative proportions in which a company s products are sold Assumptions of CVP Analysis Selling price is constant the price of a product service will not change as volume changes Costs are linear and can be accurately divided into variable and fixed elements variable element is constant per unit and the fixed element is constant in total over the entire relevant range In multiproduct companies the sales mix is constant In manufacturing companies inventories do not change number of units produced equals number of units sold
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