CHAPTER 5 COST VOLUME PROFIT RELATIONSHIPS COST VOLUME PROFIT CVP ANALYSIS I a CVP Analysis Powerful tool that helps managers understand the relationships among cost volume and profit to then make decisions i Focuses on how profits are affected by 1 Selling Prices 2 Sales Volume 3 Unit Variable Costs 4 Total Fixed Costs 5 Mix of Produces sold b Begins with Contribution Income Statement i Contribution income statement emphasizes the behavior of costs making it helpful for managers in judging the impacts on profits of changes in selling price cost or volume ii Sales Variable Expenses and Contribution Margin should be expressed on a per unit basis as well as in total c Contribution Margin the amount remaining form sales revenue after variable expenses have been deducted Amount available to cover fixed expenses and then to provide profits for the period i Used FIRST to cover the fixed expenses then remainder goes towards profits 1 2 If CM isn t sufficient to cover the fixed expenses then a loss occurs for the period If CM covers only the fixed expenses then the break even point is reached Level of sales at which profit is zero Neither a profit nor loss is seen 3 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 4 Ex a For each additional product sold during the month 100 more in CM b becomes available to help cover the fixed expenses If enough products can be sold to generate the 35 000 in CM then all the fixed expenses will be covered and the company will break even for the month d CVP Relationships in Equation Form i Contribution Format Income Statement 1 Profit Sales Variable Expenses Fixed Expenses ii When a company has only a single product equation can be refined as 1 Sales Selling Price Per Unit x Quantity Sold P x Q 2 Variable Expenses Variable Expenses Per Unit x Quantity Sold V x Q 3 Profit P x Q V x Q Fixed Expenses a Ex For 351 sold Profit 250 x 351 150 x 351 35 000 100 iii Unit Contribution Margin Unit CM Selling Price Per Unit Variable Expenses Per Unit 1 Profit Unit CM x Q Fixed Expenses a Ex Profit 100 x 351 35 000 100 e CVP Relationships In Graphic Form Show the relationship among revenue cost profit and volume Highlights CVP relationships over wide ranges of activity i Preparing CVP Graph Break Even Chart Unit Volume on X axis and Dollars on Y Axis 1 Draw line parallel to the volume axis to represent fixed expenses 2 Choose some volume of unit sales and plot the point representing total expense at the sales volume selected Draw a line through it back to the point where the fixed expense line intersects the dollars axis 3 Again Choose a sales volume and plot the representing total sales dollars at the activity level selected Draw a line through this point back to origin 4 ii The break even point is where the total revenue and total expense lines cross iii Profit Graphs Based on Profit Unit CM X Q Fixed Expenses 1 Break even point is the volume of sales at which profit is zero Profit steadily increases to the right of the break even point as the sales volume increases and that the loss becomes steadily worse to the left of the break even point as the sales volume decreases f CM Ratio Contribution margin as a percentage of sales i Add a column to which sales revenues variable expenses and contribution margin are expressed as a percentage of sales ii CM Ratio Contribution Margin Sales 1 For companies with only one product CM ratio Unit CM Unit Sell Price iii The impact on Net Operating Income of any given dollar change in total sales can be computed by applying the CM ratio to the dollar change 1 Profit CM Ratio x Sales Fixed Expenses g Applications of CVP Concepts i Variable Expense Ratio The ratio of variable expenses to sales 1 Variable Expense Ratio Variable Expenses Sales 2 CM Ratio CM Sales 1 Variable Expense Ratio ii Can use this to find projected numbers and deciding if change is worth it 1 Ex Is the 10 000 increase in monthly advertising worth the 30 000 increase in sales 520 units 2 Yes b c 3 Other ways to find this Using Incremental Analysis a Incremental Analysis Consider only the revenue cost and volume that will change if program is implemented based on knowledge of previous sales h Change in Variable Costs and Sales Volume Compare Expected CM to Present CM i Ex Using higher quality components that increase variable costs by 10 speaker but is predicted that change will increase sales to 480 speakers month compared to currently selling 400 Is this worth it ii 10 increase in variable costs decrease the Unit CM down 10 to 90 iii iv Higher quality components should be used because increase CM margin therefore increasing the NOI i Change in Fixed Cost Sales Price and Sales Volume Compare Expected CM to Present CM i Ex Cuts selling price by 20 speaker and increases advertising by 15 000 per month Believes unit sales will increase by 50 to 600 speakers month Should changes be made ii 20 decrease in selling price will decrease Unit CM down 20 to 80 iii iv v Change shouldn t be made because decrease Net Operating Income j Change in Variable Cost Fixed Cost and Sales Volume i Ex Pay salespersons sales commission of 15 speaker sold rather than the 6000 month flat salary Sales manager is confident that change would increase monthly sales by 15 to 460 speakers per month Should change be made ii Salary compensation will change both fixed and variable expenses Fixed expenses will decrease by 6 000 from 35 000 to 29 000 Variable expenses per unit would increase by 15 from 150 to 165 and CM would decrease from 100 to 85 1 Reduction in fixed expenses has effect of increasing net operating income iii iv Change should be made because NOI Increases k Change in Selling Price i Quoted Price Variable Price Desired Profit Bulk Sale ii Ex Company will make a bulk sale of 150 if price is negotiated not disturbing the regular sales or the company s total fixed expenses What price should be quoted to wholesaler if company is seeking a 3 000 profit iii iv Fixed expenses aren t included because fixed expenses are not affected by the bulk sale so II TARGET PROFIT AND BREAK EVEN ANALYSIS all of the CM margin increases the company s profits i How much would we have to sell to make a profit of x per month How much do we have to sell to avoid incurring a loss b Target Profit Analysis Estimate what sales volume is needed to achieve a specific target profit Company wants to know what sales
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