Chapter 20Cost-Volume-Profit Analysis

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.

Variable Costs

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Fixed Costs

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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.

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.

High-Low Method

• Use three steps to separate the variable and fixed costs.

• Step 1: Identify the highest and lowest levels of activity and calculate the variable cost per unit.

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High-Low Method

• 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.

• Step 2: Calculate the total fixed costs.

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High-Low Method

• Using the variable costs per unit and the fixed costs per unit, we can determine the total mixed costs at various levels of productivity.

• Step 3: Create and use an equation to show the behavior of a mixed cost.

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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?

• A traditional income statement classifies costs by function: – Product costs– Period costs

• A contribution margin income statement classifies costs by behavior:– Variable costs– Fixed costs

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Contribution Margin

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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.

Unit Contribution Margin

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• The contribution margin can be expressed as a unit amount.

• Note: The terms unit contribution margin and contribution margin per unit are used interchangeably.

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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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

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Target Profit—Three Approaches• CVP analysis can be used to estimate the

amount of sales needed to achieve a target profit.

• There are three methods of estimated sales required to make a profit:– 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• If Smart Touch Learning desires a target

profit of $6,000, using the equation approach, it finds it needs to sell 80 units.

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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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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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$40,000 / $500 = 80 units

Breakeven Point—A Variation of Target Profit

• The breakeven point calculation is a variation of the target profit calculation.

• The breakeven point is the point at which total revenues equal total costs.

• The same three approaches used for target profit can be used to determine the breakeven point.

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Breakeven Point—A Variation of Target Profit

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Units sold rounded up from 53.3 to 54

Breakeven Point—A Variation of Target Profit

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Breakeven Point—A Variation of Target Profit

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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 number of units needed to breakeven increases from 54 to 60.

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CM per unit drops from $225 to $200

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 54 to 56.

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CM per unit drops from $225 to $215

Changes in Fixed Costs• If Smart Touch Learning’s fixed costs

increase from $12,000 to $15,000, the number of units needed to break even increases from 54 to 67.

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How Is CVP Analysis Used for Sensitivity Analysis?

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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.

• Used to evaluate the risk of current operations and their plans for the future.

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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

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Sales Mix

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