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Managerial Accounting: A Decision Focus, 8e Chapter 5: Cost- Volume-Profit Analysis Chapter 5 Importance of CVP Analysis l Understanding the relationship between costs, revenue, and volume l Short-run decision making l Planning Chapter 5 Cost Behavior Patterns l Cost behavior means how a cost will react to changes in the level of business activity. – Total variable costs change when activity changes. – Total fixed costs remain unchanged when activity changes. Chapter 5 Total Variable Cost Example Your total long distance telephone bill Total Long Distance is often based on how Telephone Bill many minutes you talk. Minutes Talked Chapter 5 Variable Cost Per Unit Example The cost per long distance minute talked may be constant. For Telephone Charge example, 10 cents per Per Minute minute. Minutes Talked Chapter 5 Total Fixed Cost Example Your monthly basic telephone bill is probably unchanged as you make more Telephone Bill Monthly Basic local calls. Number of Local Calls Chapter 5 Fixed Cost Per Unit Example The average cost per Monthly Basic Telephone local call decreases as more local calls are Bill per Local Call made. Number of Local Calls Chapter 5 Cost Behavior Patterns Chapter 5 Mixed Costs l Contain both fixed and variable components. l Example: monthly electric utility charge – Fixed service fee – Variable charge per kilowatt hour used Chapter 5 Mixed Costs Total Variable Cost Portion Fixed Portion Activity Chapter 5 Step Costs Total cost increases to a new higher cost for the next higher range of activity. Cost Total cost remains constant within a narrow range of activity. Activity Chapter 5 Curvilinear Costs Costs that increase when activity increases, but in a non-linear manner. Total Cost Activity Chapter 5 The Linearity Assumption and the Relevant Range A straight line closely approximates a curvilinear variable cost line within the relevant range. Relevant Total Cost Range Accountant’s Straight-Line Approximation (constant unit variable cost) Activity Chapter 5 Two Methods for Analyzing Costs l Scatter Diagram l High-Low Method Objective: y = a + bx where: y = total cost a = fixed cost b = unit variable cost x = number of units Chapter 5 Scatter Diagram Draw a line through the plotted data points so that about an equal numbers of points fall above and below the line. 1,000’s of Dollars 20 * ** * Total Cost in * * ** 10 * * 0 0 1 2 3 4 Activity, 1,000’s of Units Produced Chapter 5 Scatter Diagram s in cost $8,000 Slope = = = $2.00 per unit s in units 4,000 units 1,000’s of Dollars 20 * ** * s in cost Total Cost in * * ** = $8,000 10 * * Total cost = $10,000 + s in units = 4,000 $2.00 per unit 0 0 1 2 3 4 Activity, 1,000’s of Units Produced Chapter 5 The High-Low Method s in cost $3,600 Ê Unit variable cost = = = $.90 s in units $4,000 Ë Fixed cost = Total cost – Total variable cost Fixed cost = $9,700 – ($.90 per unit × 9,000 units) Fixed cost = $9,700 – $8,100 = $1,600 Ì Total cost = Fixed cost + Variable cost (Y = a + bx) Y = $1,600 + $0.90x Chapter 5 Cost-Volume-Profit Analysis Objective: Uses: Determine the effects Cost-volume-profit that changes in selling analysis may be used prices, costs, and/or to analyze a number of volume will have on situations such as profits in the short run. changing sales price, changing variable cost, or changing fixed cost. Chapter 5 Cost-Volume-Profit Chart Sales Costs and Revenue Break-even Point Income in Dollars Total costs Loss Units of Activity Chapter 5 Cost-Volume-Profit Analysis Contribution margin is amount by which revenue Contribution margin is amount by which revenue exceeds variable costs of producing the revenue. exceeds variable costs of producing the revenue. Chapter 5 Cost-Volume-Profit Analysis Contribution margin goes to cover fixed costs. Contribution margin goes to cover fixed costs. After covering fixed costs, any remaining After covering fixed costs, any remaining contribution margin contributes to income. contribution margin contributes to income. Chapter 5 Cost-Volume-Profit Analysis How much contribution margin does OK How much contribution margin does OK need to cover its fixed costs (break even)? need to cover its fixed costs (break even)? Answer $30,000 Answer $30,000 Chapter 5 Finding the Break-Even Point Break-even (BE) Computation Fixed costs BEunits = Unit contribution margin Chapter 5 Finding the Break-Even Point The break-even formula may also be expressed in sales dollars: Fixed costs BE$ = Contribution margin ratio CMR = contribution margin as a percentage of sales. Chapter 5 Finding the Breakeven Point CMR Chapter 5 CVP Analysis Example l Tulip Co. sells its plant cartons at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to break even? l a. 100,000 units l b. 40,000 units l c. 200,000 units l d. 66,667 units Chapter 5 CVP Analysis Example (Answer) l Tulip Co. sells its plant cartons at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to break even? l a. 100,000 units l b. 40,000 units Fixed costs $200,000 l c. 200,000 units Unit contribution = $5.00 – $3.00 l d. 66,667 units = 100,000 units Chapter 5 CVP Analysis Example 2 l Use the CMR formula to determine the amount of sales revenue Tulip Co. needs to break even. Fixed costs, unit sales price, and unit variable cost are unchanged. l a. $200,000 l b. $300,000 l c. $400,000 l d. $500,000 Chapter 5 CVP Analysis Example 2 (Answer) l Use the CMR formula to determine the amount of sales revenue Tulip Co. needs to break even. Fixed costs, unit sales price, and unit variable cost are unchanged. l a. $200,000 l b. $300,000 l c. $400,000 CMR = ($5.00 – $3.00) ÷ $5.00 = .40 l d. $500,000 BE$ = $200,000 ÷ .40 = $500,000 Chapter 5 Calculating Break-Even for a Multiproduct Company The CMR is a function of the sales mix of the products. BE$ = Fixed costs ÷ CMR BE$ = Fixed costs ÷ CMR BE$ = 27,000 ÷ .45 = $60,000 BE$ = 27,000 ÷ .45 = $60,000 Chapter 5 Margin of Safety Excess of current sales over the break-even volume of sales. Margin of safety = Total sales – Break-even sales May also be expressed as a percentage of sales. Chapter 5 Calculating Sales Volume Needed for Desired Income Add desired income to fixed costs in the numerator of the break-even equation. Fixed costs + Desired income BEunits = Unit contribution margin Fixed costs + Desired income BE$ = Contribution margin ratio Chapter 5 CVP Example 3 l Tulip Co. sells its plant cartons at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to earn income of $40,000? l a. 100,000 units l b. 120,000 units l c. 80,000 units l d. 200,000 units Chapter 5 CVP Example 3 l Tulip Co. sells its plant cartons at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to earn income of $40,000? l a. 100,000 units Fixed costs + Desired income l b. 120,000 units Unit contribution l c. 80,000 units $200,000 + $40,000 = 120,000 units $5.00 – $3.00 l d. 200,000 units Chapter 5 Cost-Volume-Profit Analysis Assumptions Ê Linearity in the relevant range – Unit sales price remains constant. – Unit variable cost remains constant. Ë Total fixed costs remain constant. Ì In multiproduct situations, product mix is known and does not change. Í All costs may be classified as either fixed or variable.