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WSU ACCTG 231 - Basics of Cost-Volume-Profit Analysis

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ACCTG 231 Lecture 11 Ch. 5Outline of Current Lecture I. Basics of Cost-Volume-Profit AnalysisII. The Contribution ApproachIII. CVP Relationships in Equation FormIV. CVP Relationships in Graphic FormV. Contribution Margin Ratio (CM Ratio)VI. The Variable Expense RatioVII. Target Profit AnalysisVIII. Equation MethodIX. The Formula MethodX. Break-Even AnalysisXI. Break-Even in Unit Sales: Equation MethodXII. The Margin of Safety XIII. Cost Structure and Profit StabilityXIV. Operating LeverageXV. Structuring Sales CommissionsXVI. The Concept of Sales MixXVII. Key Assumptions of CVP AnalysisCurrent LectureI. Basics of Cost-Volume-Profit Analysis- The contribution income statement is helpful to managers in judging the impact on profits of changes in selling price, cost, or volume. The emphasis is on cost behavior- Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted- CM is used first to cover fixed expenses. Any remaining CM contributes to net operating incomeII. The Contribution Approach- Sales, variable expenses, and contribution margin can also be expressed on a per unit basis.- We do not need to prepare an income statement to estimate profits at a particular sales volume. Simply multiply the number of units sold above break-even by the contribution margin per unitIII. CVP Relationships in Equation FormThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.- The contribution format income statement can be expressed in the following equation:o Profit=(Sales –Variable expenses) –Fixed expenses- When a company only has one product, we can further refine this equation as shown:o Sales: Quantity sold (Q) x Selling price per unit (P) = Sales (QxP)o Variable expenses: Quantity sold (Q) x Variable expenses per unit (V) = Variable expenses (QxV)o Profit = (P x Q –V x Q) –Fixed expenses- It is often useful to express the simple profit equation in terms of the unit contribution margin (Unit CM) as follows:o Unit CM = Selling price per unit –Variable expenses per unito Unit CM = P –V Thus: - Profit = (P x Q – V x Q) – Fixed expenses- Profit = (P-V) x Q –Fixed expenses- Profit = Unit CM x Q –Fixed expensesIV. CVP Relationships in Graphic Form- The relationships among revenue, cost, profit, and volume can be expressed graphically by preparing a CVP graph- In a CVP graph, unit volume is usually represented on the horizontal (X) axis and dollars on the vertical (Y) axis- Draw a line parallel to the volume axis to represent total fixed expenses- Choose some sales volume and plot the point representing total expenses (fixed and variable). Draw a line through the data point back to where the fixed expenses line intersects the dollar axis- Choose some sales volume, and plot the point representing total sales. Draw a line through the data point back to the point of originV. Contribution Margin Ratio (CM Ratio)- The CM ratio is calculated by dividing the total contribution margin by total sales- It can be calculated by CM Ratio = (CM per unit)/(SP per unit)o It is calculated by dividing the contribution margin per unit by the selling price per unit- The relationship between profit and the CM ratio can be expressed using the following equationo Profit = (CM ratio x Sales) –Fixed expensesVI. The Variable Expense Ratio- The variable expense ratio is the ratio of variable expenses to sales. It can be computed by dividing the total variable expenses by the total sales, or in a single product analysis, it can be computed by dividing the variable expenses per unit by the unit selling priceVII. Target Profit Analysis- We can compute the number of units that must be sold to attain a target profit using either:o Equation method, or o Formula method- Can also compute the target profit in terms of sales dollars using either the equation method or the formula methodVIII. Equation Method- Profit = Unit CM x Q –Fixed expenseso Our goal is to solve for the unknown “Q” which represents the quantity of units that must be sold to attain the target profito Unit CM x Q = Profit + Fixed expenseso Q = (Profit + Fixed expenses)/Unit CM- Profit = CM ratio x Sales –Fixed expenseso Our goal is to solve for the unknown “Sales,” which represents the dollar amount of sales that must be sold to attain the target profitIX. The Formula Method- The formula uses the following equation:o Unit sales to attain the target profit = (Target profit + Fixed expenses)/(CM per unit)- We can calculate the dollar sales needed to attain a target profito Dollar sales to attain the target profit = (Target profit + Fixed expenses)/CM ratioX. Break-Even Analysis- The equation and formula methods can be used to determine the unit sales and dollar sales needed to achieve a target profit of zeroXI. Break-Even in Unit Sales: Equation Method- Profits = Unit CM x Q –Fixed expenseso Profits are zero at the break-even point- In Formula Method: o Unit sales to break even = (Fixed expenses)/(CM per unit)o Dollar sales to break even = (Fixed expenses)/(CM ratio)XII. The Margin of Safety - The margin of safety in dollars is the excess of budgeted (or actual) sales over thebreak-even volume of saleso Margin of safety in dollars = Total sales –Break-even sales- The margin of safety can be expressed in terms of the number of units soldXIII. Cost Structure and Profit Stability- Cost structure refers to the relative proportion of fixed and variable costs in an organization- Managers often have some latitude in determining their organization’s cost structure- There are advantages and disadvantages to high fixed cost (or low variable cost) and low fixed cost (or high variable cost) structureso An advantage of a high fixed cost structure is that income will be higher in good years compared to companies with lower proportion of fixed costso A disadvantage of a high fixed cost structure is that income will be lower in bad years compared to companies with lower proportion of fixed costs- Companies with low fixed cost structures enjoy greater stability in income across good and bad years.XIV. Operating Leverage- Operating leverage is a measure of how sensitive net operating income is to percentage changes in sales- It is a measure, at any given level of sales, of how a percentage change in sales volume


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