MANAC

Session-7

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Learning Objectives (1 of 2)
• 1.1 Explain the features of cost-volume-profit (CVP) analysis
• 1.2 Determine the breakeven point and output level needed to achieve a target
operating income
• 1.3 Understand how income taxes affect CVP analysis
• 1.4 Explain how managers use CVP analysis to make decisions
• 1.5 Explain how sensitivity analysis helps managers cope with uncertainty

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Learning Objectives (2 of 2)
1.6 Use CVP analysis to plan variable and fixed costs
1.7 Apply CVP analysis to a company producing multiple products
1.8 Apply CVP analysis in service and not-for-profit organizations
1.9 Distinguish contribution margin from gross margin

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Essentials of CVP Analysis
• Managers want to know how profits will change as the units sold of a product or
service change.
• Managers like to use “what-if” analysis to examine the possible outcomes of
different decisions so they can make the best one.
• You have already studied total revenues, total costs and income.
• Here, we take a closer look at the relationship among the elements (selling price,
variable costs, fixed costs)

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A Five-step Decision-Making Process in
Planning and Control-Revisited
1. Identify the problem/uncertainties
2. Obtain information
3. Make predictions about the future
4. Make decisions by choosing between alternatives using cost-
volume-profit (CVP) analysis
5. Implement the decision, evaluate performance and learn.

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Foundational Assumptions Used in CVP
Analysis (1 of 2)
1. Changes in production/sales volume are the sole cause of cost and revenue
changes.
2. Total costs consist of fixed costs and variable costs.
3. Revenue and costs behave and can be graphed as a linear function (a straight
line).
4. Selling price, variable cost per unit, and fixed costs are all known and constant.

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Foundational Assumptions Used in CVP
Analysis (2 of 2)
5. In many cases, only a single product will be analysed. If multiple products are
studied, their relative sales proportions are known and constant.
6. The time value of money (interest) is ignored.

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Basic CVP Equations
Contribution Margin =
Total Revenue - Total Variable Costs
Contribution Margin per unit =
Selling Price –VC per unit
Contribution Margin =
Contribution Margin per unit * Number of units sold
Operating Income =
Contribution Margin - Fixed costs
Contribution Margin Ratio (or Percentage) =
Contribution Margin / Revenue
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More CVP Relationships
• Manipulation of the basic equations (prior slide) yields an extremely important
and powerful tool called Contribution Margin.
• Contribution margin equals revenue minus variable costs.
• Contribution margin per unit equals unit selling price less unit variable costs but
can also be determined by taking the contribution margin divided by the number
of units sold.

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Cost-Volume-Profit (CVP) Equation
and Contribution Margin (CM)
Methods
• EQUATION METHOD:
REVENUE - VARIABLE COSTS - FIXED COSTS = OPERATING INCOME

• CM METHOD:
[(SP – VC) X Q] - FC = OI
[(CM per unit) X Q] - FC = OI

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Cost-Volume-Profit – You Try It! Problem
REVENUE - VARIABLE - FIXED = OPERATING
COSTS COSTS INCOME
Tiny’s Cabinets sells cabinets for $600 each
Variable cost is $350 each
Annual fixed costs are $20,000
If Tiny sells 100 cabinets, what it his operating income?

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Cost-Volume-Profit – You Try It! Solution
Tiny’s Cabinets sells cabinets for $600 each
Variable cost is $350 each
Annual fixed costs are $20,000
If Tiny sells 100 cabinets, what it his operating income?
Solution: [(SP X Q) - (VC X Q)] - FC = OI
($600*100) - ($350*100) = Contribution Margin
CM - $20,000 = Operating Income
$60,000 - $35,000 - $20,000 = $5,000

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Breakeven Point
The breakeven point (BEP) is that quantity of output sold at which total revenue
equals total cost - that is, the quantity of output sold results in $0.00 of operating
income.
Recall our contribution margin method equation:
[(SP x Q) - VC x Q)] - FC = OI
If we set OI to 0 and solve, we’ll get the BEP.

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Breakeven Point-Example (1 of 2)
Let’s try this for Tiny’s Cabinets. Recall that his SP = $600, VC = $350 and Fixed
Costs are $20,000, annually.
[(SP x Q) - (VC x Q)] - FC = OI
($600 x Q) - ($350 x Q) - $20,000 = 0
$250 x Q = 20,000
Q = 80
Here’s another way to find the answer:
Breakeven revenues = FC / CM%
Breakeven units = FC / CM per unit
Let’s try this for Tiny’s Cabinets.
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Breakeven Point-Example (2 of 2)
Breakeven units = FC / CM per unit
Tiny’s CM per unit = $600 - $350 = $250
Tiny’s CM % = $250/$600 = 41.67%
$20,000 / $250 = 80

Breakeven revenues = $20,000/41.67% = $47,996

which is equal to 80 x $600 (allowing for rounding)

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CVP: Graphically

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CVP: Graphically

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Breakeven Point-Extended:
Profit Planning/Target Income
The breakeven formula can be modified to become a profit planning tool by adding
target operating income to fixed costs in the numerator.
Let’s say that Tiny wants to make $30,000 Operating Income:
Qty of Units = (FC + Target Operating Income)/CM per unit
Q = ($20,000 + $30,000)/$250
Q = 200

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CVP and Income Taxes
After-tax profit (Net Income) can be calculated by:
Net Income = Operating Income * (1-Tax Rate)
Net income can be converted to operating income for use in the CVP equation
Operating Income = I I Net Income I
(1-Tax Rate)
Note: the CVP equation will continue to use operating income. We’ll use this
conversion formula to obtain the operating income value when provided with Net
Income.

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CVP and Income Taxes – Tiny’s Cabinets
Net income can be converted to operating income for use in the CVP Equation
Operating Income = I I Net Income I
(1-Tax Rate)
What if Tiny wanted to earn $30,000 Net Income instead of Operating Income?
His tax rate is 35%. Tiny’s CM per unit = $250 (we solved for it earlier)

Quantity of Units = (FC + Target Operating Income)/CM per unit

Q = ($20,000 + [$30,000/(1-35%)]/$250
Q = ($20,000 + $46,154)/$250 = 265
Earlier Q was 200

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Using CVP Analysis for Decision Making (1 of
3)
Remember Tiny? As is, he expects to sell 100 cabinets. What if Tiny spent $5,000
on advertising and estimated it would increase his sales by 10%. Should he do it?
SP = $600, VC = $350 and Fixed Costs are $20,000

Blank Sales without Advertising Sales with Advertising

Units Sold 100 110

Revenues (SP $600) $60,000 $66,000
Variable Cost ($350) $35,000 $38,500
Fixed Costs $20,000 $25,000
Operating Income $ 5,000 $ 2,500
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Using CVP Analysis for Decision Making (2 of
3)

As we see from the prior screen, though Tiny’s sales increase with the advertising
expenditure, his Operating Income decreases by $2,500.
Tiny will be better off if he doesn’t advertise.
What if I told you that a more detailed analysis indicated that Tiny’s sales would
increase by 25% instead of 10%. Should he do it?
Here’s a quick way to check that. If sales increase 25%, they’ll increase by 25
units. 25 units X Contribution Margin per unit of $250 ($600 - $350) = $6,250.
That is $1,250 greater than the $5,000 Tiny would have to spend. So, in this case,
Tiny will be better off spending money on the advertising.

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Using CVP Analysis for Decision Making (3 of
3)

• The concept of using CVP analysis for decision-making works just as well if you
are thinking about decreasing prices. If you decrease your price, you’d expect
more unit sales. To determine if the combination of lower prices with higher unit
sales will improve Operating Income, use CVP analysis.
• This type of strategic decision entails risk. We use CVP to evaluate how the
Operating Income will change, but we cannot be certain that our estimates of
increased sales will occur.
• Managers use electronic spreadsheets to systematically and efficiently conduct
CVP-based sensitivity analysis to test how sensitive their conclusions are to
different assumptions.

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Sensitivity Analysis
• CVP provides structure to answer a variety of “what-if” scenarios.
• “What” happens to profit “if”:
• Selling price changes
• Volume changes
• Cost structure changes
• Variable cost per unit changes
• Fixed costs change
As an example, if a company determines that an ad campaign costing $15,000 is
expected to increase sales 25%, should they proceed? This is very similar to the
analysis we did for Tiny’s Cabinets. The question cannot be properly answered
without doing this type of analysis.
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Margin of Safety-Defined
• The margin of safety calculation answers a very important question:
• If budgeted revenues are above the breakeven point, how far can they fall before
the breakeven point is reached.
• In other words, how far can they fall before the company will begin to lose
money.

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Margin of Safety – An Indicator of Risk

• The margin of safety (MOS) measures the distance between budgeted sales and
breakeven (BE) sales:
• MOS = Budgeted Sales - BE Sales
• The MOS ratio removes the firm’s size from the output and expresses itself in the
form of a percentage:
• MOS Ratio = MOS / Budgeted Sales
• Let’s try this for Tiny’s Cabinets. Recall that his SP = $600, VC = $350 and Fixed
Costs are $20,000, annually. He expects to sell 100 units. What is MOS and MOS
ratio?

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Cost Structure

• Managers make strategic decisions that affect the cost structure of the company
• The cost structure is simply the relationship of fixed costs and variable costs to
total costs.
• We can use CVP-based sensitivity analysis to highlight the risks and returns as
fixed costs are substituted for variable costs in a company’s cost structure.
• The risk-return trade-off across alternative cost structures can be measured as
operating leverage.

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Operating Leverage = CM/Operating Income
• The risk-return tradeoff across alternative cost structures can be measured as
operating leverage.
• Operating leverage describes the effects that fixed costs have on changes in
operating income as changes occur in units sold and contribution margin.
• Organisations with a high proportion of fixed costs in their cost structures have
high operating leverage.
• In the presence of fixed costs, the degree of operating leverage is different at
different sales levels.

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Using Operating Leverage to Estimate
Changes to Operating Income
• Firms operating at high leverage: Small increases in sales lead to large increases
in operating income. Small decreases in sales result in relatively large decreases in
operating income, leading to a greater risk of operating losses.
• We can use Operating Leverage to estimate changes to Operating Income that will
result from a percentage change in sales.
• Operating Leverage * % Change in Sales = Percentage change in Operating
Income
• For example, if sales increase 50% and operating leverage is 1.67, you should
expect operating income to increase 83.5% (50% x 1.67)

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• What actions are managers taking to reduce their fixed costs?
• Many companies are moving their manufacturing facilities from the United States
to lower-cost countries like Mexico and China.
• To substitute high fixed costs with lower variable costs, companies purchase
products from lower-cost suppliers instead of manufacturing them.
• These actions reduce both costs and operating leverage.

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Effects of Sales Mix on CVP
• Sales Mix is the quantity or proportion of various products or services that
constitute a company’s total unit sales. It is often the case that the various
products or services have different contribution margins.
• Up to this point, we’ve assumed a single product; more realistically, we’ll have
multiple products with different costs and different margins.
• We can use the same formula in our CVP calculations but must use an average
contribution margin for the products.
• This technique assumes a constant mix at different levels of total unit sales.

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CVP for Service and Not-For-Profit
Organizations
• CVP isn’t just for merchandising and manufacturing companies.
• Service and Not-For-Profit businesses need to focus on measuring their output,
which is different from the units sold that we’ve been dealing with.
• For example, a service agency might measure how many persons they assist, or an
airline might measure how many passenger miles they fly.
• What measure might a hotel use?
• Room-nights occupied

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Contribution Margin versus Gross Margin
• Recall from Chapter 2 that Gross Margin = Revenue – Cost of Goods Sold
• In Chapter 3, we learned about Contribution Margin which is Revenue – All
Variable Costs
• Gross Margin measures how much a company charges for its products over and
above the cost of acquiring or producing them.
• Contribution Margin indicates how much of a company’s revenue is available to
cover fixed costs.
• This is especially significant in the manufacturing sector where businesses carry
inventory

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Contribution Margin and Gross Margin for Tiny’s Cabinets (Produced 100
cabinets, sold 90;SP $600; VC $350; FC $20,000 (15,000 Mfg))
Line Item Contribution Line item Gross Margin
Margin
Sales (90 * $600) $54,000 Sales (90 * $600) $54,000
Variable Costs $31,500 Cost of Goods Sold $46,500
(90*$350) (VC 90*$350; FC-
Mfg $15000)
Contribution Margin $22,500 Gross Margin $ 7,500
Fixed Mfg Costs $15,000

Fixed Non-Mfg Costs $ 5,000 Non-Manufacturing $ 5,000

Costs
Operating Income $ 2,500 Operating Income $2,500
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