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Chapter 20Cost-Volume-Profit Analysis
© 2018 Pearson Education, Inc.
Chapter 20 Learning Objectives
1. Determine how changes in volume affect costs
2. Calculate operating income using contribution margin and contribution margin ratio
3. Use cost-volume-profit (CVP) analysis for profit planning
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Chapter 20 Learning Objectives
4. Use CVP analysis to perform sensitivity analysis
5. Use CVP analysis to calculate margin of safety, operating leverage, and multiproduct breakeven points
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Learning Objective 1
Determine how changes in volume affect costs
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HOW DO COSTS BEHAVE WHEN THERE IS A CHANGE IN VOLUME?
• Some costs change as the volume of sales increases or decreases. Other costs are not affected by changes in volume.
• Different types of costs are:– Variable costs– Fixed costs– Mixed costs
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Variable Costs
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Variable costs remain constant per unit but change in total as volume changes.
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Variable Costs
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Fixed Costs
Fixed costs do not change in total over wide ranges of volume of activity.
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Fixed Costs
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Fixed Costs
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Mixed Costs
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Mixed costs have both fixed and variable components.
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Mixed Costs
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High-Low Method
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• A method to separate mixed costs into variable and fixed components is the high-low method.
• It uses three steps to separate the variable and fixed costs.
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High-Low Method
Step 1: Identify the highest and lowest levels of activity and calculate the variable cost per unit.
• Now that we have calculated the variable costs per unit, we can calculate the portion of the mixed costs that relates to the fixed costs in the next step.
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High-Low Method
Step 2: Calculate the total fixed costs.
• Using the variable costs per unit and the fixed costs per unit, we can determine the total mixed costs at various levels of productivity in step 3.
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High-Low Method
Step 3: Create and use an equation to show the behavior of a mixed cost.
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High-Low Method
Using this equation, the estimated manufacturing equipment maintenance cost for 400 tablets would be as follows:
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Relevant Range and Relativity
The relevant range is the range of volume where total fixed costs and variable costs per unit remain constant.
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Learning Objective 2
Calculate operating income using contribution margin and contribution margin ratio
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WHAT IS CONTRIBUTION MARGIN, AND HOW IS IT USED TO COMPUTE
OPERATING INCOME?
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• The difference between net sales revenue and variable costs is the contribution margin.
• It is called contribution margin because it is the amount that contributes to covering fixed costs.
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Unit Contribution Margin
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• The contribution margin can be expressed as a unit amount.
• The terms unit contribution margin and contribution margin per unit are used interchangeably.
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Contribution Margin Ratio
• A third way to express contribution margin is as a ratio.
• Contribution margin ratio is the ratio of contribution margin to net sales revenue.
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• A traditional income statement classifies costs by function: – Product costs– Period costs
• A contribution margin income statementclassifies costs by behavior:– Variable costs– Fixed costs
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Contribution Margin Income Statement
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Contribution Margin Income Statement
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Learning Objective 3
Use cost-volume-profit (CVP) analysis for profit planning
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HOW IS COST-VOLUME-PROFIT (CVP) ANALYSIS USED?
• Managers use information about cost behavior to make business decisions.
• Cost-volume-profit (CVP) analysis is a planning tool that looks at the relationships among costs and volume and how they affect profits (or losses).
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Assumptions
• The price per unit does not change as volume changes.
• Managers can classify each cost as variable, fixed, or mixed.
• The only factor that affects total costs is change in volume, which increases or decreases variable and mixed costs.
• Fixed costs do not change.• There are no changes in inventory levels.
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Breakeven Point—Three Approaches
• CVP analysis can be used to estimate the amount of sales needed to achieve the breakeven point.
• The breakeven point is the sales level at which the company does not earn a profit or a loss but has an operating income of zero.
• There are three methods of estimated sales required to break even:– Equation approach
– Contribution margin approach
– Contribution margin ratio approach
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The Equation Approach
An equation can be used to estimate the number of units a company needs to sell to achieve target profit or total sales revenue.
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The Equation Approach
How many tablets must Smart Touch Learning sell to break even?
We can prove the required sales as follows:
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The Contribution Margin Approach
• The contribution margin approach is a shortcut method of computing the required sales in units.
• The equation approach is rewritten to derive the following equation:
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The Contribution Margin Approach
• Using this formula, we can enter the given amounts to calculate the required sales in units.
• When the dollars cancel out during the division process, the result is expressed in units.
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The Contribution Margin Approach
We can prove our answer of 60 units using the contribution margin income statement format:
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Contribution Margin Ratio Approach
The contribution margin ratio approach computes required sales in terms of sales dollars rather than in units.
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Target Profit
• A variation of the breakeven point calculation is the target profit calculation.
• Target profit is the operating income that results when net sales revenue minus variable and fixed costs equals management’s profit goal.
• The same three approaches used for breakeven point calculation can be used to determine the target profit.
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CVP Graph―A Graphic Portrayal
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Learning Objective 4
Use CVP analysis to perform sensitivity analysis
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HOW IS CVP ANALYSIS USED FOR SENSITIVITY ANALYSIS?
• Managers can use CVP relationships to conduct sensitivity analysis.
• Sensitivity analysis is a “what if” technique that estimates profit or loss results if sales price, cost, volume, or underlying assumptions change.
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Changes in the Sales Price
If the sales price changes from $500 to $475, the units needed to break even increases from 60 to 68.
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Changes in Variable Costs
If one of Smart Touch Learning’s suppliers raises prices, and variable costs increase from $275 to $285, the number of units needed to break even increases from 60 to 63.
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Changes in Fixed Costs
If Smart Touch Learning’s fixed costs increase from $13,500 to $16,500, the number of units needed to break even increases from 60 to 74.
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HOW IS CVP ANALYSIS USED FOR SENSITIVITY ANALYSIS?
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Using Sensitivity Analysis
Smart Touch Learning’s management wants to do better than break even. Consider the following two scenarios:
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Cost Behavior Versus Management Behavior
• One of the CVP assumptions is that the only factor that affects total costs is a change in volume, which increases or decreases variable and mixed costs.
• However, costs are often asymmetrical. • Costs increase more when sales volume is
increasing than costs decrease when sales volume is decreasing, a phenomenon known as cost stickiness.
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Cost Behavior Versus Management Behavior
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Learning Objective 5
Use CVP analysis to calculate margin of safety, operating leverage, and multiproduct breakeven points
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WHAT ARE SOME OTHER WAYS CVP ANALYSIS CAN BE USED?
• CVP analysis can be used for estimating target profits and breakeven points, as well as sensitivity analysis.
• Three additional applications of CVP are: – Margin of safety– Operating leverage– Sales mix
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Margin of Safety
• Margin of safety is the excess of expected sales over breakeven sales.
• It is used to evaluate the risk of current operations and their plans for the future.
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Operating Leverage
• The cost structure of a company is the proportion of fixed costs to variable costs.
• Operating leverage predicts the effects that fixed costs will have on changes in operating income when sales volume changes.
• The degree of operating leverage can be measured by dividing the contribution margin by the operating income.
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Operating Leverage
• For Company A, the percentage change in operating income will be 2.5 times the percentage change in sales.
• For Company B, the percentage change in operating income will be 1.25 times the percentage change in sales.
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Sales Mix
• Most companies sell more than one product.
• Sales price and variable costs differ for each product.
• Sales mix, or product mix, is the combination of products that make up total sales.
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Sales Mix
Step 1: Calculate the weighted-average contribution margin per unit as follows:
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Sales Mix
Step 2: Calculate the breakeven point in units for the “package” of products:
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Sales Mix
Step 3: Calculate the breakeven point in units for each product in the sales mix “package.” Multiply the “package” breakeven point in units by each product’s proportion of the sales mix.
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Sales Mix
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Sales Mix
Suppose Cool Cat would like to earn operating income of $20,000.
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Sales Mix
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