MA_session 4-5

CLEANLINESS IS NEXT TO GODLINESS
Duration: 150 mins

Slides: 18
LM THAPAR SCHOOL OF MANAGEMENT,

THAPAR INSTITUTE OF ENGINEERING & TECHNOLOGY
Masters of Business Administration
Course: Managerial Accounting

Faculty: Dr. Sonia Garg (Email: [email protected])
Session 4-5 : Cost-Volume-Profit Analysis

Session Learning Objectives
• Explain the features of CVP analysis
• Output required for break even point and target operating income
• Effect of Income taxes on CVP analysis
• Application of CVP for

– Sensitivity analysis
– Operating Leverage
• CVP analysis for multiple products
22/12/2024 Cost-Volume-Profit Analysis 2

Assumptions of CVP
• Volume is the sole cause of changes in cost
• Total costs = Fixed cost + Variable cost
• Revenue and variable costs have linear relationship with

volume
• For multiple products, relative sales proportion is known and

constant
• The time value of money is ignored

Basic Formulae
• Revenue – Variable costs – Fixed costs = Operating Income
• Revenue = Selling price * Quantity sold
• Variable costs = Variable cost per unit * Quantity sold
• Contribution margin = Revenue – Variable costs
• Contribution margin per unit = Selling price – Variable cost per unit
• Contribution margin = Contribution margin per unit * Quantity sold
• Contribution margin ratio = Contribution margin per unit/Selling price

Break Even Point
Sales – VC – FC = Operating Income (OI)
(SP x Q) – (VCu x Q) – FC = OI
Q (SP – VCu) – FC = OI
Q (CMu) – FC = OI
(Sales/SP)*(CMu) – FC =OI
(Sales*CMR) – FC = OI
At Break-even OI = zero, this implies

Break even quantity = FC/CMu
Break even sales = FC/CMR
Target Operating Income
• Q (CMu) – FC = OI
• Q = (FC + OI)/CMu
• Profit planning can be done by deciding on a

target operating income and finding out the
quantity required to generate that operating
income
CVP Graphically
• FC = 2000
• VCu = 120
• SP = 200
• CMu = SP-VCu
=200-120=80
• BEQ = FC/CMu
=2000/80=25

CVP and Income Taxes
• Income taxes are very important for firms
• Net Income = Operating Income *(1 – Tax rate)
• In the CVP equation, operating income can be

replaced by Net Income/(1-tax rate)

Example: CVP for decision making
Spear Products typically earns a contribution margin ratio of 30% and has
current fixed costs of $90,000. Spear’s general manager is considering
spending an additional $25,000 to do one of the following:
• Start a new ad campaign that is expected to increase sales revenue by
8%.
• License a new computerized ordering system that is expected to
increase its contribution margin ratio to 35%.
Sales revenue for the coming year was initially forecast to equal
$1,500,000 (that is, without implementing either of the above options).
Required
• For each option, how much will projected operating income increase
or decrease relative to initial predictions?
• By what percentage would sales revenue need to increase to make
the ad campaign as attractive
22/12/2024 as the ordering
Cost-Volume-Profit Analysis system? 9
Solution
• CM = 30%; FC=90000; Sales=1500000
• OI = 30% of 1500000 – 90000= 450000 – 90000= 360000
• Option 1
– Sales = 1.08*1500000=1620000
– OI = 30% of 1620000 – (90000+25000)= 486000 – 115000= 371000
• Option 2
– OI = 35% of 1500000 – (90000+25000)= 525000 – 115000= 410000
• TOI = 410000
– Sales – VC = TOI + FC =410000 + +25000 + 90000 = 525000 or
– Sales –VC =CM =30% of sales
– Thus sales = 525000/0.3 = 1750000
– % increase in sales = 250000/1500000 = 16.67%
Sensitivity Analysis
• CVP analysis can provide answers to many
what if type questions
• What happens to profit if

– Selling price changes
– Volume changes
– Cost structure changes
– Variable cost changes
– Fixed cost changes
Margin of Safety
• One indicator of risk, the Margin of Safety (MOS)
measures the distance between budgeted sales and
breakeven sales
• MOS = Budgeted Sales – Break even 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

Example
Unit sale price $30
Variable cost per unit $6
Fixed costs per year $280,000
Required
• Contribution margin ratio.
• Sales required to break even.
• Sales required to earn an annual operating income of
$50,000.
• The margin of safety sales volume if annual sales total
50,000 units.
• Operating income if annual sales total 50,000 units.
Solution
• SP = 30; VCu = 6; FC = 280000
• CMR = CMu /SP = (30-6)/30 = 0.8

• Break even sales = FC/CMR = 280000/0.8 =
350000
• TOI = 50000; FC +TOI = 280000+50000 = 330000;
Sales = 330000/0.8 = 412500
• MOS = (50000*30) – 350000 = 1150000
• OI = (24*50000) – 280000 = 920000
Operating Leverage
• The risk-return tradeoff across alternate cost
structures can be measured as operating leverage
• It measures the change in operating income with a

change in quantity sold due to the given fixed costs
• Degree of operating leverage=

contribution margin/operating income

CVP for multiple products
• To find break even Sales Mix is constant (3:2)
point, find BEP of a A B Total
sales mix bundle Expected Sales 60 40 100

Selling Price 2000 1000
• Contribution margin Variable Cost per unit 1200 700
per bundle = 3*800 Contribution Margin 800 300
+2*300 = 3000 per unit
Revenues 12000 40000 160000
0
• BEP in bundles = Variable Costs 72000 28000 100000
Contribution Margin 48000 12000 60000
45000/3000 = 15 Fixed Costs 45000
• Implies 45 product A Operating Income 15000
and 30 product B
CVP for multiple products (contd.)
• To find Break even sales
• Multiply break even quantity into selling price

– Product A: 45*2000 = 90000
– Product B: 30*1000 = 30000
– Total 120000

Case
• Hospital Supply Inc

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CLEANLINESS IS NEXT TO GODLINESS

Duration: 150 mins

LM THAPAR SCHOOL OF MANAGEMENT,

Course: Managerial Accounting

Session 4-5 : Cost-Volume-Profit Analysis

• Effect of Income taxes on CVP analysis

• Application of CVP for

• CVP analysis for multiple products

22/12/2024 Cost-Volume-Profit Analysis 2

• Total costs = Fixed cost + Variable cost

• Revenue and variable costs have linear relationship with

• For multiple products, relative sales proportion is known and

• The time value of money is ignored

• Revenue = Selling price * Quantity sold

• Variable costs = Variable cost per unit * Quantity sold

• Contribution margin = Revenue – Variable costs

• Contribution margin = Contribution margin per unit * Quantity sold

• Contribution margin ratio = Contribution margin per unit/Selling price

At Break-even OI = zero, this implies

• Profit planning can be done by deciding on a

22/12/2024 Cost-Volume-Profit Analysis 7

• Net Income = Operating Income *(1 – Tax rate)

• In the CVP equation, operating income can be

22/12/2024 Cost-Volume-Profit Analysis 8

• What happens to profit if

• MOS = Budgeted Sales – Break even sales

• MOS ratio = MOS/ Budgeted Sales

• CMR = CMu /SP = (30-6)/30 = 0.8

• It measures the change in operating income with a

• Degree of operating leverage=

22/12/2024 Cost-Volume-Profit Analysis 15

sales mix bundle Expected Sales 60 40 100

• Multiply break even quantity into selling price

22/12/2024 Cost-Volume-Profit Analysis 17

22/12/2024 Cost-Volume-Profit Analysis 18

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