6 Cost-Volume-Profit

Analysis: Additional Issues

Learning Objectives
1 Apply basic CVP concepts.

Explain the term sales mix and its effects on break-

2 even sales.

Determine sales mix when a

3 company has limited resources.

4 Indicate how operating leverage affects profitability.

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 LEARNING
OBJECTIVE 1 Apply basic CVP concepts.

CVP analysis is:

 The study of the effects of changes in costs and volume
on a company’s profit.
 Important to profit planning.
 Critical in management decisions such as:
► determining product mix,
► maximizing use of production facilities,
► setting selling prices.

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 Basic Concepts

 Management often wants the information reported in a

special format income statement.
 CVP income statement is for internal use only:
► Costs and expenses classified as fixed or variable.
► Reports contribution margin as a total amount and
on a per unit basis.

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 Basic Concepts

Illustration 6-1
Basic CVP income
statement

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 Basic Concepts Illustration 6-2
Detailed CVP
income statement

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 Basic Computations

BREAK-EVEN ANALYSIS
Illustration: Vargo Video’s CVP income statement (Ill. 6-2)
shows that total contribution margin is $320,000, and the
company’s contribution margin per unit is $200. Contribution
margin can also be expressed in the form of the contribution
margin ratio which in the case of Vargo is 40% ($200 ÷ $500).

Illustration 6-3 and 6-4

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 Basic Computations

TARGET NET INCOME

Once a company achieves break-even sales, a sales goal can be
set that will result in a target net income
Illustration: Assuming Vargo’s target net income is $250,000,
required sales in units and dollars to achieve this are:

(Fixed Costs + Target Unit Contribution Required Sales

÷ =
Net Income) Margin in Units

($200,000 + $250,000) ÷ $200 = 2,250 units

Illustration 6-5
Target net income in units

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 Basic Computations

TARGET NET INCOME

Once a company achieves break-even sales, a sales goal can be
set that will result in a target net income
Illustration: The contribution margin ratio is used to compute
required sales in dollars.

(Fixed Costs + Target Contribution Required Sales

÷ =
Net Income) Margin Ratio in Dollars

($200,000 + $250,000) ÷ .40 = $1,125,000

Illustration 6-6
Target net income in dollars

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 Basic Computations

MARGIN OF SAFETY
 tells us how far sales can drop before the company will
operate at a loss.
 can be expressed in dollars or as a ratio.

Illustration: Assume Vargo’s sales are $800,000:

Actual (Expected ) Break-Even Margin of Safety

- =
Sales Sales in Dollars

$800,000 - $500,000 = $300,000

Illustration 6-7
Margin of safety in dollars

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 Basic Computations

MARGIN OF SAFETY
 tells us how far sales can drop before the company will
operate at a loss.
 can be expressed in dollars or as a ratio.

Illustration: Vargo’s sales could drop by $300,000, or 37.5%,

before the company would operate at a loss.

Margin of Safety in Actual (Expected) Margin of Safety

- =
Dollars Sales in Ratio

$300,000 - $800,000 = 37.5%

Illustration 6-8
Margin of safety ratio

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 CVP and Changes in the Business
Environment

Illustration: Original camcorder sales and cost data for Vargo

Video:

Illustration 6-9

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 CVP and Changes in the Business
Environment

Case I: A competitor is offering a 10% discount on the selling

price of its camcorders. Management must decide whether to
offer a similar discount.
Question: What effect will a 10% discount on selling price ($500
x 10% = $50) have on the breakeven point?

Unit Contribution Break-Even

Fixed Costs ÷ =
Margin Sales

$200,000 ÷ $150 = 1,334 units

Illustration 6-10
Computation of break-even
sales in units

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 CVP and Changes in the Business
Environment

Case II: Management invests in new robotic equipment that will

lower the amount of direct labor required to make camcorders.
Estimates are that total fixed costs will increase 30% and that
variable cost per unit will decrease 30%.
Question: What effect will the new equipment have on the sales
volume required to break even?
Unit Contribution Break-Even
Fixed Costs ÷ =
Margin Sales

$260,000 ÷ ($500 - $210) = 897 units (rounded)

Illustration 6-11
Computation of break-even
sales in units
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 CVP and Changes in the Business
Environment

Case III: Vargo’s principal supplier of raw materials has just

announced a price increase. The higher cost is expected to
increase the variable cost of camcorders by $25 per unit.
Management decides to hold the line on the selling price of the
camcorders. It plans a cost-cutting program that will save $17,500
in fixed costs per month. Vargo is currently realizing monthly net
income of $80,000 on sales of 1,400 camcorders.
Question: What increase in units sold will be needed to maintain
the same level of net income?

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 CVP and Changes in the Business
Environment

Case III:

Variable cost per unit increases to $325 ($300 + $25).

Fixed costs are reduced to $182,500 ($200,000 - $17,500).
Contribution margin per unit becomes $175 ($500 - $325).

(Fixed Cost + Target Unit Contribution Required Sales

÷ =
Net Income) Margin in Units

($182,500 + $80,000) ÷ $175 = 1,500

Illustration 6-12
Computation of required sales

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 Basic Concepts

Question
Croc Catchers calculates its contribution margin to be less
than zero. Which statement is true?
a. Its fixed costs are less than the variable cost per unit.
b. Its profits are greater than its total costs.
c. The company should sell more units.
d. Its selling price is less than its variable costs.

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6-17 LO 1
 1 CVP Analysis

Krisanne Company reports the following operating results for the month of June
2017.

To increase net income, management is considering reducing the selling price

by 10%, with no changes to unit variable costs or fixed costs. Management is
confident that this change will increase unit sales by 25%. Using the contribution
margin technique, compute the break-even point in units and dollars and margin
of safety in dollars (a) assuming no changes to sales price or costs, and (b)
assuming changes to sales price and volume as described above. (c) Comment
on your findings.
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 1 CVP Analysis

Krisanne Company reports the following operating results for the month of June
2017.

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 1 CVP Analysis

Krisanne Company reports the following operating results for the month of June
2017.

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 1 CVP Analysis

Krisanne Company reports the following operating results for the month of June
2017.

(c) The increase in the break-even point and the decrease in the margin of
safety indicate that management should not implement the proposed
change. The increase in sales volume will result in contribution margin of
$112,500 (6,250 x $18), which is $7,500 less than the current amount.

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 LEARNING Explain the term sales mix and its
OBJECTIVE 2 effects on break-even sales.

Break-Even Sales in Units

 Sales mix is the relative percentage in which a
company sells its products.
 If a company’s unit sales are 80% printers and 20%
computers, its sales mix is 80% to 20%.
 Sales mix is important because different products
often have very different contribution margins.

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 Break-Even Sales in Units

Companies can compute break-even sales for a mix of two or

more products by determining the weighted-average unit
contribution margin of all the products.
Illustration: Vargo Video sells not only camcorders but TV sets
as well. Vargo sells its two products in the following amounts:
1,500 camcorders and 500 TVs. The sales mix, expressed as a
function of total units sold, is as follows.

Illustration 6-13
Sales mix as a percentage
of units sold

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 Break-Even Sales in Units

Additional information related to Vargo Video.

Illustration 6-13

Illustration 6-14
Per unit data—sales mix

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 Break-Even Sales in Units

First, determine the weighted-average contribution margin.

Illustration 6-14

Illustration 6-15
Weighted-average unit contribution margin

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 Break-Even Sales in Units

Second, use the weighted-average unit contribution margin to

compute the break-even point in units
Illustration 6-15

Illustration 6-16
Break-even point in units

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 Break-Even Sales in Units

 With a break-even point of 1,000 units, Vargo must sell:

► 750 Camcorders (1,000 units x 75%)
► 250 TVs (1,000 units x 25%)
 At this level, the total contribution margin will equal the fixed
costs of $275,000.

Illustration 6-17
Break-even proof—sales units

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 Break-Even Sales in Dollars

 Works well if the company has many products.

 Calculates break-even point in terms of sales dollars for
► divisions or
► product lines,
► NOT individual products.

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 Break-Even Sales in Dollars

Illustration: Kale Garden Supply Company has two divisions.

Illustration 6-18
Cost-volume-profit data for Kale Garden Supply

Illustration 6-19
6-29 Contribution margin ratio for each division
LO 2
 Break-Even Sales in Dollars

First, determine the weighted-average contribution margin.

Illustration 6-20
Calculation of weighted-average contribution margin Illustration 6-21
Calculation of break-even
point in dollars

Second, calculate
break-even point in
dollars.

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 Break-Even Sales in Dollars

 With break-even sales of $937,500 and a sales mix of 20%

to 80%, Kale must sell:
► $187,500 from the Indoor Plant division

► $750,000 from the Outdoor Plant division

 If the sales mix becomes 50% to 50%, the weighted

average contribution margin ratio changes to 35%, resulting
in a lower break-even point of $857,143.

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 Break-Even Sales in Dollars

Question
Net income will be:

a. Greater if more higher-contribution margin units are

sold than lower-contribution margin units.
b. Greater is more lower-contribution margin units are
sold than higher-contribution margin units.
c. Equal as song as total sales remain equal, regardless
of which products are sold.
d. Unaffected by changes in the mix of products sold.

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6-33 LO 2
 2 Sales Mix Break-Even

Manzeck Bicycles International produces and sells three different types

of mountain bikes. Information regarding the three models is shown
below.

The company’s total fixed costs to produce the bicycles are $7,500,000.
(a) Determine the sales mix as a function of units sold for the three
products.

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 2 Sales Mix Break-Even

(a) Determine the sales mix as a function of units sold for the three
products.

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 2 Sales Mix Break-Even

(b) Determine the weighted-average unit contribution margin.

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 2 Sales Mix Break-Even

(c) Determine the total number of units that the company must sell to
break even.

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 2 Sales Mix Break-Even

(d) Determine the number of units of each model that the company
must sell to break even.

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 LEARNING Determine sales mix when a company
OBJECTIVE 3 has limited resources.

Determining Sales Mix with Limited Resources

 All companies have limited resources whether it be floor
space, raw materials, direct labor hours, etc.
 Management must decide which products to sell to
maximize net income.

Illustration: Vargo makes camcorders and TVs. Machine

capacity is limited to 3,600 hours per month.

Illustration 6-22
6-39 Contribution margin and machine hours LO 3
 Sales Mix with Limited Resources

Calculate the contribution margin per unit of limited resource.

Illustration 6-23
Contribution margin per
Management should produce more camcorders unit of limited resource

if demand exists or else increase machine

capacity.

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 Sales Mix with Limited Resources

If Vargo is able to increase machine capacity from 3,600 hours to

4,200 hours, the additional 600 hours could be used to produce
either the camcorders or TVs.

Illustration 6-24
Incremental analysis—
To maximize net income, all 600 hours should computation of total
contribution margin
be used to produce and sell camcorders.

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 Sales Mix with Limited Resources

Theory of Constraints
 Approach used to identify and manage constraints so as to
achieve company goals.
 Company must continually
► identify its constraints and
► find ways to reduce or eliminate them, where
appropriate.

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 Sales Mix with Limited Resources

Question
If the contribution margin per unit is $15 and it takes 3.0
machine hours to produce the unit, the contribution margin per
unit of limited resource is:

a. $25.
b. $5.
c. $4.
d. No correct answer is given.

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 3 Sales Mix with Limited Resources

Carolina Corporation manufactures and sells three different types of

high-quality sealed ball bearings for mountain bike wheels. The
bearings vary in terms of their quality specifications—primarily with
respect to their smoothness and roundness. They are referred to as
Fine, Extra-Fine, and Super-Fine bearings. Machine time is limited.
More machine time is required to manufacture the Extra-Fine and
Super-Fine bearings. Additional information is provided below.

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 3 Sales Mix with Limited Resources

(a) Ignoring the machine time constraint, what strategy would appear
optimal?
Solution

The Super-Fine bearings have the highest unit contribution margin.

Thus, ignoring any manufacturing constraints, it would appear that the
company should shift toward production of more Super-Fine units.
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 3 Sales Mix with Limited Resources

(b) What is the contribution margin per unit of limited resource for each
type of bearing?
Solution

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 3 Sales Mix with Limited Resources

(c) If additional machine time could be obtained, how should the

additional capacity be used?
Solution

The Fine bearings have the highest contribution margin per unit of
limited resource even though they have the lowest unit contribution
margin. Given the resource constraint, any additional capacity should
be used to make Fine bearings. LO 3
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 LEARNING Indicate how operating leverage affects
OBJECTIVE 4 profitability.

Cost Structure is the relative proportion of fixed versus

variable costs that a company incurs.
 May have a significant effect on profitability.
 Company must carefully choose its cost structure.

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 Cost Structure

Illustration: Vargo Video and one of its competitors, New Wave

Company, both make camcorders. Vargo Video uses a traditional,
labor-intensive manufacturing process. New Wave Company has
invested in a completely automated system. The factory employees
are involved only in setting up, adjusting, and maintaining the
machinery. Illustration 6-25
CVP income statements for two companies

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 Effect on Contribution Margin Ratio
Illustration 6-25

First let’s look

at the
contribution
margin ratios.

Illustration 6-26
Contribution margin ratio
for two companies

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 Effect on Contribution Margin Ratio
Illustration 6-26

 New Wave contributes 80 cents to net income for each dollar of

increased sales while Vargo only contributes 40 cents.
 New Wave’s cost structure which relies on fixed costs is more
sensitive to changes in sales.

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 Effect on Break-Even Point
Illustration 6-27
Calculate the break-even point. Computation of break-even
point for two companies

 New Wave needs to generate $150,000 more in sales than Vargo

to break-even.
 Because of the greater break-even sales required, New Wave is
a riskier company than Vargo.

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 Effect on Margin of Safety
Illustration 6-28
Computation of margin of safety ratio Computation of margin of
safety ratio for two companies

 The difference in ratios reflects the difference in risk between New

Wave and Vargo.
 Vargo can sustain a 38% decline in sales before operating at a loss
versus only a 19% decline for New Wave.

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 Operating Leverage

 Extent that net income reacts to a given change in sales.

 Higher fixed costs relative to variable costs cause a

company to have higher operating leverage.

 When sales revenues are increasing, high operating

leverage means that profits will increase rapidly.

 When sales revenues are declining, too much operating

leverage can have devastating consequences.

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 Operating Leverage

DEGREE OF OPERATING LEVERAGE

 Provides a measure of a company’s earnings volatility.
 Computed by dividing total contribution margin by net
income.
Illustration 6-29

New Wave’s earnings would go up (or down) by about two times

(5.33 ÷ 2.67 = 1.99) as much as Vargo’s with an equal increase
in sales.
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 Operating Leverage

Question
The degree of operating leverage:
a. Can be computed by dividing total contribution margin
by net income.
b. Provides a measure of the company’s earnings
volatility.
c. Affects a company’s break-even point.
d. All of the above.

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 4 Operating Leverage

Rexfield Corp., a company specializing in crime scene investigations, is

contemplating an investment in automated mass-spectrometers. Its
current process relies on a high number of lab technicians. The new
equipment would employ a computerized expert system. The
company’s CEO has requested a comparison of the old technology
versus the new technology. The accounting department has prepared
the following CVP income statements for use in your analysis.

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 4 Operating Leverage

(a) Compute the degree of operating leverage for the company under
each scenario.

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 4 Operating Leverage

(b) Discuss your results.

The degree of operating leverage measures the company’s sensitivity

to changes in sales. By switching to a cost structure dominated by fixed
costs, the company would significantly increase its operating leverage.
As a result, with a percentage change in sales, its percentage change
in net income would be 2.33 (7 ÷ 3) times as much with the new
technology as it would under the old.
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 LEARNING APPENDIX 6A: Explain the differences between
OBJECTIVE 5 absorption costing and variable costing.

Under variable costing, product costs consist of:

 Direct Materials
 Direct Labor
 Variable Manufacturing Overhead

The difference between absorption and variable costing is:

Illustration 6A-1
Difference between absorption costing and variable costing

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 Variable versus Absorption Costing

The difference between absorption and variable costing:

 Under both costing methods, selling and administrative
expenses are treated as period costs.
 Companies may not use variable costing for external
financial reports because GAAP requires that fixed
manufacturing overhead be treated as a product cost.

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 Comparing Absorption with Variable
Costing

Illustration: Premium Products Corporation manufactures a

polyurethane sealant, called Fix-It, for car windshields. Relevant data
for Fix-It in January 2017, the first month of production, are as
follows.

Illustration 6A-2
Sealant sales and cost data for
Premium Products Corporation

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 Comparing Absorption with Variable
Costing

Per unit manufacturing cost under each approach.

Illustration 6A-3

The manufacturing cost per unit is $4 ($13 -$9) higher for absorption
costing because fixed manufacturing costs are treated as product
costs.

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 ABSORPTION COSTING EXAMPLE

Illustration 6A-4
Absorption costing income statement
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 VARIABLE COSTING EXAMPLE

Illustration 6A-5
Variable costing income statement
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 Comparing Absorption with Variable
Costing

Question
Fixed manufacturing overhead costs are recognized as:

a. Period costs under absorption costing.

b. Product costs under absorption costing.
c. Product costs under variable costing.
d. Part of ending inventory costs under both
absorption and variable costing.

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 Decision-Making Concerns

 Generally accepted accounting principles require that

absorption costing be used for the costing of inventory for
external reporting purposes.
 Net income measured under GAAP (absorption costing) is
often used internally to
► evaluate performance,
► justify cost reductions, or
► evaluate new projects.

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 Decision-Making Concerns

 Some companies have recognized that net income

calculated using GAAP does not highlight differences
between variable and fixed costs and may lead to poor
business decisions.
 These companies use variable costing for internal reporting
purposes.

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 Potential Advantages of Variable Costing

 The use of variable costing is consistent with cost–volume–

profit analysis.
 Net income under variable costing is unaffected by changes
in production levels. Instead, it is closely tied to changes in
sales.
 The presentation of fixed costs in the variable costing
approach makes it easier to identify fixed costs and to
evaluate their impact on the company’s profitability.

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 5Comprehensive
Variable Costing

Franklin Company produces and sells tennis balls. The following

costs are available for the year ended December 31, 2017. The
company has no beginning inventory. In 2017, 8,000,000 units
were produced, but only 7,500,000 units were sold. The unit
selling price was $0.50 per ball. Costs and expenses were as
follows.

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 5Comprehensive
Variable Costing

(a) Compute the manufacturing cost of one unit of product using

variable costing.
(b) Prepare a 2017 income statement for Franklin Company using
variable costing.

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 Copyright

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