ACCT 102 Management Accounting Lecture 3

1
ACCT 102Management AccountingLecture 3 4
Cost-Volume-Profit (CVP) Analysis
2
CVP Analysis

• Decision making and planning do not involve only
  the determination of relevant cost behavior
• They also involve a consideration of the combined
  effect on both cost and revenue functions of
  changes in the level of activity
• They are achieved by examining the relationship
  of costs, volume and revenues which in turn gives
  insight into the incremental impact on the
  profitability of the various choices open to
  management - CVP analysis.

3
CVP Assumptions

• All costs are classified as fixed or variable
  with unit level activity cost drivers.
• The total cost function is linear within the
  relevant range.
• The total revenue function is linear within the
  relevant range.
• The analysis is for a single product, or the
  sales mix of multiple products is constant.
• There is only one activity cost driver unit or
  dollar sales volume.

4
The Profit Formula
? R - Y
Where ? Profit
R Total revenues Y Total costs
5
The Profit Formula
R pX Y a bX
Where p Unit selling price
a Fixed costs b Unit variable
costs X Unit sales
6
Detailed Profit Formula
? pX - (a bX)
7
Break-even Point (BEP)

• Break-even Point
• ? 0
• Since ? pX - (a bX) Refer to previous
  slide
• 0 pX - (a bX)
• pX (a bX)
• TR TC
• Until break-even sales are reached, the object of
  interest operates at a loss
• Beyond this point, increasing levels of profits
  are achieved

8
BEP

• Example Ace Pte Ltd
• Selling price (per unit) 12
• Fixed costs per period 50,000
• Semi-variable
• Fixed component 30,000
• Variable component (per unit) 2
• Variable costs (per unit) 5
• Relevant range of output (units) 6,000 50,000

9
BEP

• Break even point (BEP) using TR TC
• At BEP, ? 0 and TR TC
• Substituting the data,
• 12x 80,000 7x
• 5x 80,000
• x 16,000 units
• Break even point in units 16000 units
• Break even point in dollar sales
• 16000 x 12 192,000

10
Contribution Margin (CM)

• BEP output level for Ace Pte Ltd is 16,000 units
• What happens if it were to sell only 15,999
  units?
• ? Px (a bx)
• ? (12 15,999) (80,000 (7 15,999))
• (191,988) (80,000 111,993)
• 191,988 191,993 5

11
CM

• If 16,001 units were sold, what would be the
  profit ?
• ? Px (a bx)
• ? (12 X 16,001) (80,000 (7 X 16,001)
• 192,012 (80,000 112,007)
• 192,012 192,007 5
• Significance of the 5 loss and 5 profit
  respectively?
• Each additional unit produced and sold generates
  an incremental profit of 5, which is given by
  the difference between the selling price of
  12/unit and the variable cost of 7/unit
• Incremental profit termed Contribution Margin
  (CM)

12
CM

• Contribution margin focuses on sales in relation
  to all variable costs
• Distinguish CM from Gross Margin (Sales COGS)
• CM per unit Selling price less variable costs
  per unit
• CM ratio CM per unit/Selling Price or
• Total CM/Sales or
• 1 VC-sales ratio
• Note CM ratio is the portion of each dollar of
  sales revenue contributed towards covering fixed
  cost and earning a profit

13
BEP (using CM approach)

• Break-even Point Formulas (using CM approach)

Break-even unit sales volume
Fixed costs

Unit contribution margin
Fixed costs Contribution margin ratio
Break-even dollar sales volume

14
BEP (using CM approach)

• CM per unit SP VC per unit
• 5
• BEP in units FC/CM per unit
• 16,000 units
• CM ratio CM per unit/SP or Total CM/Sales
• 0.417
• BEP in FC / CM ratio
• 192,000

15
Incremental Analysis

• Focuses on changes occurring in revenues, costs,
  and/or volume. Looks at
• what if price per unit were to increase or
  decrease,
• what if variable cost per unit or fixed costs
  were to increase or decrease, and
• what if sales volume were to increase decrease
  and so on.

16
Incremental Analysis

• Question
• Using the previous example, if Ace Pte Ltd
  current sales is 25,000 units and it is confident
  that it can increase its sales by another 10,000
  units through a promotion program that will cost
  30,000, should the company carry out the
  promotion program?

17
Incremental Analysis

• Answer
• Since every dollar of contribution margin after
  the BEP is profit, Ace should carry out the
  promotion program if the additional contribution
  margin from the additional sales is in excess of
  the additional cost.
• Increase in contribution 50,000
• Increase in fixed cost 30,000
• Incremental profit 20,000

18
Incremental Analysis

• Question
• Ace estimates that if the selling price is
  reduced by 1, it can generate additional sales
  of 5,000 units over its current sales of 25,000
  units. Should Ace proceed with the price
  reduction?

19
Incremental Analysis

• Answer
• If the sales price is reduced by 1, total
  contribution from the current sales will reduce
  by 25,000.
• Contribution from the additional sales will
  amount to 20,000.
• Net loss as a result of reducing sales price by
  1 will be 5,000.

20
Contribution and Functional Income Statements

• Contribution income statement Costs are
  classified according to behavior as variable or
  fixed
• Functional income statement Costs are classified
  according to function, e.g. COGS, selling
  expenses, administrative expenses
• Contribution income statements provides better
  information to internal decision makers.

21
Contribution and Functional Income Statements
22
Contribution Income Statement
Benchmark Paper Company Contribution Income
Statement for a Monthly Volume of 5,400 Cartons
Sales (5,400 x 8) 43,200 Less variable
costs Direct materials (5,400 x 1.00)
5,400 Direct labor (5,400 x 0.25) 1,350 Manufa
cturing overhead (5,400 x 1.25) 6,750 Selling
and administrative (5,400 x 0.50)
2,700 -16,200 Contribution margin 27,000 Less
fixed costs Manufacturing 5,000 Selling and
administrative 10,000 -15,000 Profit 12,000
23
Functional Income Statement
Benchmark Paper Company Functional Income
Statement for a Monthly Volume of 5,400 Cartons
Sales (5,400 x 8) 43,200 Less cost of goods
sold Direct materials (5,400 x 1.00)
5,400 Direct labor (5,400 x 0.25) 1,350 Variab
le Mfg. overhead (5,400 x 1.25) 6,750 Fixed
manufacturing overhead 5,000 -18,500 Gross
margin 24,700 Less other expenses Variable
selling and admin. (5,400 x 0.50)
2,700 Fixed selling and administrative
10,000 Profit 12,000
24
Contribution Income Statement
Ratio to
Total Per Unit Sales
Sales (5,400 units) 43,200 Variable
costs -16,200 Contribution margin 27,000 Fixed
costs -15,000 Profit 12,000
8 1.000 -3 -0.375 5 0.625
If sales increase by 100 cartons per month, what
will be the increase in net income?
100 x 5 500
25
Contribution Income Statement
3,000 units per month
26
Profit Planning
Assume Benchmarks management desires to know the
unit sales volume required to achieve a monthly
profit of 18,000.
6,600 units
27
Profit Planning
Benchmark desires a profit of 12,000.
28
Margin of safety

• Margin of safety is the excess of a companys
  actual sales above its BEP point (in units or
  dollars)
• It is the amount that sales can drop before it
  starts to make a loss.
• It can be expressed as
• Units (actual units less break-even units)
• Dollars (actual sales in dollars less break-even
  sales in dollars), or
• Percentage (excess of units/sales dollar over
  breakeven units/sales dollar as a of budgeted
  or actual units/sales dollar).

29
Margin of safety

• Using data from Benchmark, assume that the sales
  for Benchmark is projected to be 4000 units. The
  margin of safety for Benchmark is
• in units 4,000 3,000 1,000 units
• in sales 32,000 24,000 8,000
• in 1000/4,000 25 or 8,000/32,000
  25

30
Graphs relating to CVP
60,000 - 50,000 - 40,000 - 30,000
- 20,000 - 10,000 - 0 -
Total Revenues and Total Costs


0 2000 4000
6000 8000
Unit Sales
CVP Graph
31
Graphs relating to CVP
20,000 - 15,000 - 5,000 -
0 - (5,000) - (10,000) - (15,000) -
Profit area
Total Profit or (Loss)


Loss area
0 20,000 40,000
60,000
Total Revenues
Profit-Volume Graph
32
Operating Leverage

• Operating leverage provides information
  concerning the relationship between a companys
  variable and fixed costs.
• Generally, companies that are highly labor
  intensive tend to have higher variable costs and
  lower fixed costs, and thus, low operating
  leverage. The reverse is also true for capital
  intensive companies.

33
Operating Leverage

• Characteristics of a highly leveraged company
• Generally have high contribution margin since
  their variable costs tend to be lower. However,
  the higher fixed costs would mean that the BEP
  would also be high.
• If selling price is relatively stable, the volume
  of sales would have high impact on profit/loss. A
  small increase in sales volume can have a major
  impact on profit/loss within a given relevant
  range.
• It is important to reduce operational leverage
  during periods of economic distress

34
Operating Leverage
Degree of operating leverage measures how a
percentage change in sales from the current level
will impact company profit/loss.
If Benchmarks sales increase 12.5 percent, how
much should profits increase?
35
Operating Leverage
Increase in sales 12.5 Degree of operating
leverage x 4.0 Increase in profits 50.0
Current profit 5,000 Increase in profits (5,000
x 50) 2,500 New profit 7,500
36
Multiple Product CVP

• Assumptions required
• Sales mix is constant
• Fixed costs is not directly related to a
  particular product. If fixed costs are directly
  related to a particular product, then the fixed
  costs should be regarded as fixed costs of the
  product and included in the separate analysis
  related to it
• gt 2 separate CVPs

37
Multiple Product CVP

• CM may be used to determine the break-even units
  volume or the units required to achieve a desired
  profit

38
Multiple Product CVP

• CM ratio may be used to determine the break-even
  dollar sales volume or the dollar sales volume
  required to achieve a desired profit

39
Multiple Product CVP
40
Multiple Product CVP
41
Multi-Level CVP

• Major limitation of traditional CVP
• Exclusive use of unit level activity cost
  drivers, i.e. does not consider other categories
  of cost drivers
• High probability of significant errors in cost
  estimation and prediction (Refer to Lecture 2
  notes)
• Expansion of CVP to incorporate non-unit activity
  cost drivers
• Difficult to develop graphical relationships
• Good way to begin is to make use of a
  contribution statement that incorporates a
  hierarchy of cost drivers

42
Multi-Level CVP

• Example General Distribution
• Sales (Multiple products) 3,000,000
• Number of sales orders 3,200
• Number of customers 400
• Cost hierarchy
• Unit level activities
• COGS 0.80 per sales dollar
• Order level activities
• Cost of processing order 20 per order
• Customer level activities
• Mail, phone, sales visits 200 per customer per
  year
• Facility level costs
• Depreciation, insurance 120,000 per year

43
Multi-Level CVP
General Distribution Multi-Level Contribution
Income Statement for the Year 2002
Sales 3,000,000 Less unit level costs Cost of
goods sold (5,000,000 x 0.80) -2,400,000 Unit
level contribution margin 600,000 Cost of
processing order (3,200 orders x 20) -
64,000 Order level contribution margin
536,000 Less customer level costs Mail, phone,
sales visits, recordkeeping, and so forth (400
customers x 200) - 80,000 Customer level
contribution margin 456,000
44
Multi-Level CVP
General Distribution Multi-Level Contribution
Income Statement for the Year 2002
Customer level contribution margin 456,000 Less
facility level costs Depreciation, manager
salaries, insurance, and so forth
-120,000 Profit 336,000
45
Multi-Level CVP
(64,000 80,000 120,000)/(1 - 0.80)
1,320,000
46
Multi-Level CVP
Cost of each order
Break-even order size (in )

Contribution margin ratio
(20)/(1 - 0.80)
100

• To break even, each order must have be for 100
  of goods.
• Discourage smaller orders

47
Multi-Level CVP
Cost of each order x Average orders per customer
Cost of customer level activity
Break-even on an average customer (in )

Contribution margin ratio
(20 x 8 200)/(1 - 0.80)
1,800

• To break even, each customer must purchase 1,800
  of goods
• Discontinue relations with customers with annual
  purchases of less than this amount or try to
  serve such customers in a less costly manner