Chapter 20 Cost-Volume- Profit Analysis

8/28/2019Chapter 20Cost-VolumeProfit Analysis 2018 Pearson Education, Inc.1Chapter 20 Learning Objectives1. Determine how changesin volume affect costs2. Calculate operatingincome usingcontribution margin andcontribution marginratio3. Use cost-volume-profit(CVP) analysis for profitplanning 2018 Pearson Education, Inc.20-221

8/28/2019Chapter 20 Learning Objectives4. Use CVP analysis toperform sensitivityanalysis5. Use CVP analysis tocalculate margin ofsafety, operatingleverage, andmultiproduct breakevenpoints 2018 Pearson Education, Inc.20-33Learning Objective 1Determine howchanges in volumeaffect costs 2018 Pearson Education, Inc.20-442

8/28/2019HOW DO COSTS BEHAVE WHENTHERE IS A CHANGE IN VOLUME? Some costs change as the volume of salesincreases or decreases. Other costs arenot affected by changes in volume. Different types of costs are:– Variable costs– Fixed costs– Mixed costs 2018 Pearson Education, Inc.20-55Variable CostsVariable costs remain constant per unit butchange in total as volume changes. 2018 Pearson Education, Inc.20-663

8/28/2019Variable Costs 2018 Pearson Education, Inc.20-77Fixed CostsFixed costs do not change in total over wideranges of volume of activity. 2018 Pearson Education, Inc.20-884

8/28/2019Fixed Costs 2018 Pearson Education, Inc.20-99Fixed Costs 2018 Pearson Education, Inc.20-10105

8/28/2019Mixed CostsMixed costs have both fixed and variablecomponents. 2018 Pearson Education, Inc.20-1111Mixed Costs 2018 Pearson Education, Inc.20-12126

8/28/2019High-Low Method A method to separate mixed costs intovariable and fixed components is the high-lowmethod. It uses three steps to separate the variableand fixed costs. 2018 Pearson Education, Inc.20-1313High-Low MethodStep 1: Identify the highest and lowestlevels of activity and calculate the variablecost per unit. Now that we have calculated the variable costsper unit, we can calculate the portion of themixed costs that relates to the fixed costs in thenext step. 2018 Pearson Education, Inc.20-14147

8/28/2019High-Low MethodStep 2: Calculate the total fixed costs. Using the variable costs per unit and the fixedcosts per unit, we can determine the total mixedcosts at various levels of productivity in step 3. 2018 Pearson Education, Inc.20-1515High-Low MethodStep 3: Create and use an equation to showthe behavior of a mixed cost. 2018 Pearson Education, Inc.20-16168

8/28/2019High-Low MethodUsing this equation, the estimatedmanufacturing equipment maintenance costfor 400 tablets would be as follows: 2018 Pearson Education, Inc.20-1717Relevant Range and RelativityThe relevant range is the range of volumewhere total fixed costs and variable costs perunit remain constant. 2018 Pearson Education, Inc.20-18189

8/28/2019Learning Objective 2Calculate operatingincome usingcontribution marginand contributionmargin ratio 2018 Pearson Education, Inc.20-1919WHAT IS CONTRIBUTION MARGIN,AND HOW IS IT USED TO COMPUTEOPERATING INCOME? The difference between net sales revenueand variable costs is the contributionmargin. It is called contribution margin because itis the amount that contributes to coveringfixed costs. 2018 Pearson Education, Inc.20-202010

8/28/2019Unit Contribution Margin The contribution margin can be expressedas a unit amount. The terms unit contribution margin andcontribution margin per unit are usedinterchangeably. 2018 Pearson Education, Inc.20-2121Contribution Margin Ratio A third way to express contribution marginis as a ratio. Contribution margin ratio is the ratio ofcontribution margin to net sales revenue. 2018 Pearson Education, Inc.20-222211

8/28/2019Contribution Margin Income Statement A traditional income statement classifiescosts by function:– Product costs– Period costs A contribution margin income statementclassifies costs by behavior:– Variable costs– Fixed costs 2018 Pearson Education, Inc.20-2323Contribution Margin Income Statement 2018 Pearson Education, Inc.20-242412

8/28/2019Learning Objective 3Use cost-volume-profit(CVP) analysis forprofit planning 2018 Pearson Education, Inc.20-2525HOW IS COST-VOLUME-PROFIT (CVP)ANALYSIS USED? Managers use information about costbehavior to make business decisions. Cost-volume-profit (CVP) analysis is aplanning tool that looks at therelationships among costs and volume andhow they affect profits (or losses). 2018 Pearson Education, Inc.20-262613

8/28/2019Assumptions The price per unit does not change asvolume changes. Managers can classify each cost asvariable, fixed, or mixed. The only factor that affects total costs ischange in volume, which increases ordecreases variable and mixed costs. Fixed costs do not change. There are no changes in inventory levels. 2018 Pearson Education, Inc.20-2727Breakeven Point—Three Approaches CVP analysis can be used to estimate the amountof sales needed to achieve the breakeven point. The breakeven point is the sales level at whichthe company does not earn a profit or a loss buthas an operating income of zero. There are three methods of estimated salesrequired to break even:– Equation approach– Contribution margin approach– Contribution margin ratio approach 2018 Pearson Education, Inc.20-282814

8/28/2019The Equation ApproachAn equation can be used to estimate thenumber of units a company needs to sell toachieve target profit or total sales revenue. 2018 Pearson Education, Inc.20-2929The Equation ApproachHow many tablets must Smart Touch Learning sell tobreak even?We can prove the required sales as follows: 2018 Pearson Education, Inc.20-303015

8/28/2019The Contribution Margin Approach The contribution margin approach is ashortcut method of computing therequired sales in units. The equation approach is rewritten toderive the following equation: 2018 Pearson Education, Inc.20-3131The Contribution Margin Approach Using this formula, we can enter the givenamounts to calculate the required sales inunits. When the dollars cancel out during thedivision process, the result is expressed inunits. 2018 Pearson Education, Inc.20-323216

8/28/2019The Contribution Margin ApproachWe can prove our answer of 60 units usingthe contribution margin income statementformat: 2018 Pearson Education, Inc.20-3333Contribution Margin Ratio ApproachThe contribution margin ratio approachcomputes required sales in terms of salesdollars rather than in units. 2018 Pearson Education, Inc.20-343417

8/28/2019Target Profit A variation of the breakeven pointcalculation is the target profit calculation. Target profit is the operating income thatresults when net sales revenue minusvariable and fixed costs equalsmanagement’s profit goal. The same three approaches used forbreakeven point calculation can be used todetermine the target profit. 2018 Pearson Education, Inc.20-35 2018 Pearson Education, Inc.20-36353618

8/28/2019CVP Graph―A Graphic Portrayal 2018 Pearson Education, Inc.20-3737Learning Objective 4Use CVP analysis toperform sensitivityanalysis 2018 Pearson Education, Inc.20-383819

8/28/2019HOW IS CVP ANALYSIS USED FORSENSITIVITY ANALYSIS? Managers can use CVP relationships toconduct sensitivity analysis. Sensitivity analysis is a “what if”technique that estimates profit or lossresults if sales price, cost, volume, orunderlying assumptions change. 2018 Pearson Education, Inc.20-3939Changes in the Sales PriceIf the sales price changes from 500 to 475,the units needed to break even increases from60 to 68. 2018 Pearson Education, Inc.20-404020

8/28/2019Changes in Variable CostsIf one of Smart Touch Learning’s suppliersraises prices, and variable costs increase from 275 to 285, the number of units needed tobreak even increases from 60 to 63. 2018 Pearson Education, Inc.20-4141Changes in Fixed CostsIf Smart Touch Learning’s fixed costs increasefrom 13,500 to 16,500, the number of unitsneeded to break even increases from 60 to 74. 2018 Pearson Education, Inc.20-424221

8/28/2019HOW IS CVP ANALYSIS USED FORSENSITIVITY ANALYSIS? 2018 Pearson Education, Inc.20-4343Using Sensitivity AnalysisSmart Touch Learning’s management wants to dobetter than break even. Consider the following twoscenarios: 2018 Pearson Education, Inc.20-444422

8/28/2019Cost Behavior VersusManagement Behavior One of the CVP assumptions is that theonly factor that affects total costs is achange in volume, which increases ordecreases variable and mixed costs. However, costs are often asymmetrical. Costs increase more when sales volume isincreasing than costs decrease when salesvolume is decreasing, a phenomenonknown as cost stickiness. 2018 Pearson Education, Inc.20-4545Cost Behavior VersusManagement Behavior 2018 Pearson Education, Inc.20-464623

8/28/2019Learning Objective 5Use CVP analysis tocalculate margin ofsafety, operatingleverage, andmultiproduct breakevenpoints 2018 Pearson Education, Inc.20-4747WHAT ARE SOME OTHER WAYS CVPANALYSIS CAN BE USED? CVP analysis can be used for estimatingtarget profits and breakeven points, aswell as sensitivity analysis. Three additional applications of CVP are:– Margin of safety– Operating leverage– Sales mix 2018 Pearson Education, Inc.20-484824

8/28/2019Margin of Safety Margin of safety is the excess of expectedsales over breakeven sales. It is used to evaluate the risk of currentoperations and their plans for the future. 2018 Pearson Education, Inc.20-4949Operating Leverage The cost structure of a company is theproportion of fixed costs to variable costs. Operating leverage predicts the effects thatfixed costs will have on changes inoperating income when sales volumechanges. The degree of operating leverage can bemeasured by dividing the contributionmargin by the operating income. 2018 Pearson Education, Inc.20-505025

8/28/2019Operating Leverage For Company A, the percentage change in operatingincome will be 2.5 times the percentage change insales. For Company B, the percentage change in operatingincome will be 1.25 times the percentage change insales. 2018 Pearson Education, Inc.20-5151Sales Mix Most companies sell more than oneproduct. Sales price and variable costs differ foreach product. Sales mix, or product mix, is thecombination of products that make uptotal sales. 2018 Pearson Education, Inc.20-525226

8/28/2019Sales MixStep 1: Calculate the weighted-average contributionmargin per unit as follows: 2018 Pearson Education, Inc.20-5353Sales MixStep 2: Calculate the breakeven point in units forthe “package” of products: 2018 Pearson Education, Inc.20-545427

8/28/2019Sales MixStep 3: Calculate the breakeven point in units foreach product in the sales mix “package.” Multiplythe “package” breakeven point in units by eachproduct’s proportion of the sales mix. 2018 Pearson Education, Inc.20-5555Sales Mix 2018 Pearson Education, Inc.20-565628

8/28/2019Sales MixSuppose Cool Cat would like to earn operatingincome of 20,000. 2018 Pearson Education, Inc.20-5757Sales Mix 2018 Pearson Education, Inc.20-585829

8/28/2019 2018 Pearson Education, Inc.20-595930

A traditional income statement classifies costs by function: –Product costs –Period costs A contribution margin income statement classifies costs by behavior: –Variable costs . CVP analysis can be used to estimate t