prepared by debby bloom-hill cma, cfm. cost-volume-profit analysis slide 4-2 chapter 4

Prepared by Debby Bloom-Hill CMA, CFM

Cost-Volume-Profit AnalysisCost-Volume-Profit Analysis

Slide 4-2

CHAPTER 4CHAPTER 4

Management QuestionsManagement Questions

Planning What level of profit should be in the

budget for the coming year? Control

Did the manager responsible for production costs do a good job of controlling costs?

Decision making Should the price be increased?

Learning objective 1: Identify common cost behavior patterns, and estimate the relation between cost and activity using account analysis and the high-low method.

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Variable Costs Costs which change directly in

proportion to changes in quantity or activity

Fixed Costs Costs which do not change when

quantity or activity volume changes

Common Cost Behavior PatternsCommon Cost Behavior Patterns

Slide 4-4Learning objective 1: Identify common cost behavior patterns, and estimate the relation between cost and activity using account analysis and the high-low method.

Mixed Costs Costs that have both variable and fixed

elements Step Costs

Fixed for a range of output, but increase when upper bound of range is exceeded

Common Cost Behavior PatternsCommon Cost Behavior Patterns


Variable CostsVariable Costs

Costs that change in proportion to changes in volume or activity An automobile manufacturer will need 400

tires to make 100 cars, but 4,000 tires to make 1,000 cars

A bakery will need 2 eggs to make 1 cake and 20 eggs to make 10 cakes

If activity increases by a certain percentage, cost increases by that same percentage

Slide 4-6 Learning objective 1: Identify common cost behavior patterns, and estimate the relation between cost and activity using account analysis and the high-low method.

A company has decided that direct labor costs are 100% variable. Last month total direct labor costs were $125,000 and total direct labor hours worked were 10,000.

1. What is the direct labor cost per hour?

$125,000 / 10,000 hours = $12.50 per hour

2. Predict labor costs in a month when 12,000 labor hours are worked

$12.50 per hour × 12,000 hours = $150,000


Variable CostsVariable Costs

Total Variable Cost = $91 × Units producedSlide 4-8 Learning objective 1: Identify common cost behavior

patterns, and estimate the relation between cost and activity using account analysis and the high-low method.

Fixed CostsFixed Costs

Do not change in response to changes in activity level

Typical fixed costs are depreciation, supervisory salaries, and building maintenance• Rent for a bakery will not double if output

increases from 100 to 200 cakes If activity increases by a certain

percentage, costs remain unchanged



Total fixed cost = $94,000



Discretionary fixed costs Management can easily change, e.g.

advertising, research & development Many companies cut back on these costs when

sales drop. This can be shortsighted. A cut in research & development can have a

negative effect on long run profitability A cut in repair and maintenance can have a

negative effect on the life of valuable assets

Committed fixed costs Cannot be easily changed, e.g. rent, insurance


Mixed CostsMixed Costs

Contain both variable and fixed cost elements

Can separate mixed costs into variable and fixed components Salesperson with base salary (fixed) and

commission on sales (variable) Base salary included with fixed costs Commission included with variable costs


Mixed CostsMixed Costs

Total cost = ($91 × Units produced) + $94,000Slide 4-13 Learning objective 1: Identify common cost behavior

patterns, and estimate the relation between cost and activity using account analysis and the high-low method.

Step CostsStep Costs

Fixed cost for a specific range of volume Increases to higher level when upper bound of

range is exceeded At that point, costs again remain fixed until

another upper bound is exceeded Step costs are often classified as either:

Step variable costs, if the range of activity where the cost is fixed is small, or

Step fixed costs, if the range of activity where the cost is fixed is large


Step Variable CostStep Variable Cost


Step Fixed CostStep Fixed Cost


Relevant RangeRelevant Range

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The relevant range is the range of activity for which assumptions as to how costs behave are reasonably valid If it is known that production is going to be

within the relevant range, we can use assumptions about the fixed and variable costs

Making assumptions about fixed and variable costs at production levels well above or below this range would not be valid


The Relevant RangeThe Relevant Range

Total step costs = $7,000 for relevant range 0 – 3,000 units produced$14,000 for relevant range 3,001 – 6,000 units$21,000 for relevant range 6,001 – 9,000 units


Cost Estimation MethodsCost Estimation Methods

Account Analysis Classify costs into variable and fixed pools

Scattergraphs Can see cost relationships visually

High-Low Method Linear estimation connects high and low

volume observations Regression Analysis

Linear estimation is best fit to observed values


Account AnalysisAccount Analysis

Most common approach Requires professional judgment of

management Management classifies costs as fixed,

variable, or mixed Total variable costs divided by activity

equals variable cost per unit Variable cost per unit and total fixed costs

can be used in cost equation


Account AnalysisAccount Analysis


ScattergraphsScattergraphs

Utilization of cost information from several previous periods

Weekly, monthly, or quarterly cost reports are useful

Plot the actual costs at the observed activity levels Look for relationship between cost and

activity, linear is ideal Use relationship to predict future costs


ScattergraphsScattergraphs

Is there a relationship between units produced and production costs? Describe the relationship.


High-Low MethodHigh-Low Method

Utilization of cost information from previous periods

Fits a straight line from lowest activity level to highest activity level Slope of the line is the estimate of the unit

variable cost The slope measures the change in cost per unit

in relation to the change in activity level Total cost at lowest or highest activity level minus

variable cost at that level equals fixed cost



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Total cost at high activity level

Total cost at low activity

level



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Month Cost

January 750 $170,000February 1,000 175,000March 1,250 205,000April 1,750 250,000May 2,000 265,000June 2,250 275,000July 3,000 400,000 HighAugust 2,750 350,000September 2,500 300,000October 1,250 210,000November 1,000 190,000December 500 150,000 Low

Total 20,000 $2,940,000

Production


Estimate Variable CostEstimate Variable Cost


Estimate Fixed CostEstimate Fixed Cost


During the past year, Island Air flew 15,000 miles in August (its busiest month) and had total costs of $300,000. In November (its least busy month) the company flew 5,000 miles and had $200,000 of costs. Using the high-low method, estimate variable cost per mile and fixed cost per month.

a. $20 of variable cost and $100,000 fixedb. $15 of variable cost and $250,000 fixedc. $10 of variable cost and $150,000 fixedd. $5 of variable cost and $250,000 fixed

Answer: cSlide 4-29


During the past year, Island Air flew 15,000 miles in August (its busiest month) and had total costs of $300,000. In November (its least busy month) the company flew 5,000 miles and had $200,000 of costs. Using the high-low method, estimate variable cost per mile and fixed cost per month.

Estimate of variable cost = = = $10

Variable cost at low level = $10 * 5,000 miles = $50,000

Fixed cost = $200,000 total – $50,000 variable = $150,000


Regression AnalysisRegression Analysis

Statistical technique Estimates the slope and intercept of a cost

equation Finds the best straight line fit to the

observations Typically statistical software packages are

utilized Spreadsheet applications like Excel® typically

include statistical operations See appendix fox Excel® example


The Relevant Range and Cost Estimation

The Relevant Range and Cost Estimation

Estimates of fixed and variable costs are valid for only a limited range of activity Known as the relevant range

Outside the relevant range, estimates of fixed and variable costs may not be useful

Actual costs may behave in a manner that is different from the common cost behavior patterns



The Profit Equation

Profit = SP(x) – VC(x) – TFC

Where: x = Quantity of units produced and sold SP = Selling price per unit VC = Variable cost per unitTFC = Total fixed cost

Fundamental to CVP analysis

Learning objective 2: Perform cost-volume profit analysis for single and multiple products.

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Break-Even Point Number of units sold that allow the company to

neither earn a profit nor incur a loss $0 = SP(x) – VC(x) – TFC

CodeConnect has the following cost structure Selling price $200.00 per unit Variable cost $81.50 per unit Monthly fixed production cost $102,000 Monthly fixed selling and administrative $63,900

Find CodeConnect’s break-even point

Slide 4-34 Learning objective 2: Perform cost-volume profit analysis for single and multiple products.


Break-Even Point$0 = SP(x) – VC(x) – TFC$0 = $200.00 (x) – $81.50(x) – $165,900

$118.50(x) = $165,900

x = 1,400 units Always round up if the breakeven point is not a

whole number

Slide 4-35Learning objective 2: Perform cost-volume profit analysis for single and multiple products.

Break-Even PointBreak-Even Point


Gabby’s Wedding Cakes creates elaborate wedding cakes. Each cake sells for $500. The variable cost of baking the cakes is $200 and the fixed cost per month is $6,000. What is the break-even point in number of units?

a. 200b. 20c. 12d. 100

Answer: b


Gabby’s Wedding Cakes creates elaborate wedding cakes. Each cake sells for $500. The variable cost of baking the cakes is $200 and the fixed cost per month is $6,000. What is the break-even point in number of units?

0 = SP(x) – VC(x) – TFC0 = (SP – VC)(x) – TFC0 = ($500 – $200)(x) – $6,0000 = $300(x) – $6,000$300(x) = $6,000x = $6,000 / $300 = 20 cakes to break even


Margin of SafetyMargin of Safety

The margin of safety is the difference between the expected level of sales and break-even sales If breakeven sales for Model DX375 is

$280,000 and expected sales are $350,000, calculate the margin of safety

The margin of safety is:

$350,000 - $280,000= $70,000


Margin of Safety RatioMargin of Safety Ratio

The margin of safety can also be expressed as a ratio Called the margin of safety ratio Equal to the margin of safety divided by

expected sales Shows what percentage sales would have to

drop before the product shows a loss


Contribution MarginContribution Margin

Difference between revenue and variable costs Contribution margin = total revenue minus

total variable costs Contribution margin per unit = selling price

minus variable cost per unit For CodeConnect’s Model DX375, the

contribution margin is the $200.00 selling price less the variable cost of $81.50

$200.00 – $81.50 = $118.50



The profit equation in terms of the contribution margin

Profit = SP(x) – VC(x) – TFC

Profit = (SP – VC)(x) – TFC

Profit = Contribution margin per unit(x) - TFC



The contribution margin per unit measures the amount of incremental profit generated by selling an additional unit For CodeConnect, how much incremental profit

would be generated by selling 100 more units?

Incremental profit = number of units sold * contribution margin per unit

Incremental profit = 100 * $118.50 = $11,850


Units Needed for Target ProfitUnits Needed for Target Profit

Solve the profit equation for the sales quantity in units Unit sales (x) needed to attain a specified

profit =


Gabby’s Wedding Cakes creates elaborate wedding cakes. Each cake sells for $500. The variable cost of baking the cakes is $200 and the fixed cost per month is $6,000

1. Calculate the break-even point in units

= = = 20 cakes

2. How many cakes must be sold to earn a profit of $9,000?

= = = 50 cakes


Contribution Margin RatioContribution Margin Ratio

The unit contribution margin ratio measures the amount of incremental profit generated by an additional dollar of sales Two methods to calculate the contribution

margin ratio1. Contribution margin divided by sales

revenue (Sales – TVC) / Sales

2. Unit contribution margin divided by selling price (SP – VC) / SP


Contribution Margin RatioContribution Margin Ratio

For the Model DX375 bar code reader, the contribution margin ratio is

= 0.5925 This indicates that the company earns an

incremental $0.5925 for every dollar of sales If sales increase $10,000 the incremental profit

is 0.5925 * $10,000 = $5,925


Dollar Sales Needed to Achieve Profit Target

Dollar Sales Needed to Achieve Profit Target

Calculate the amount of sales dollars needed to earn a monthly profit of $35,550


“What If” Analysis“What If” Analysis

“What if” analysis examines what will happen if an action is taken The profit equation can show how profit will

be affected by various options under consideration CodeConnect is selling 3,000 units at $200,

with variable cost of $81.50 and fixed cost of $165,900

Management is considering a change to $80.00 variable cost and fixed cost of $215,900



Change in fixed and variable costs Without the change, the profit is

$200(3,000) - $81.50(3,000) - $165,900 = $189,600

If the price and quantity stay the same, the profit assuming the alternative is selected would be

$200(3,000) - $80(3,000) - $215,900 = $144,100

The alternative would hurt profitability



Change in selling price Any one of the variables in the profit

equation can be considered For example, if CodeConnect sells 3,000 units,

what selling price is required to earn a profit of $200,000?

$200,000 = SP(3,000) - $81.50(3,000) - $165,900

SP(3,000) = $610,400

SP = $203.47


Matthews Consulting expects to work 5,000 hours next month. It has variable costs of $100 per hour and fixed costs of $600,000. What price must the company charge to earn a monthly profit of $900,000?

a. $500

b. $350

c. $400

d. $200

Answer: c


Matthews Consulting expects to work 5,000 hours next month. It has variable costs of $100 per hour and fixed costs of $600,000. What price must the company charge to earn a monthly profit of $900,000?

$900,000 = SP(5,000) - $100(5,000) - $600,000$900,000 = SP(5,000) - $1,100,000SP(5,000) = $2,000,000SP = $2,000,000 / 5,000 = $400


Multiproduct AnalysisMultiproduct Analysis

Contribution margin approach Used if the items sold are similar Calculate a weighted average contribution

margin per unit Use the weighted average contribution margin

in the profit formula to calculate breakeven point and target sales

The relative product mix is then used to calculate the required sales of individual items



Slide 4-55

The sales mix is 2:1 Model A, Model B The company has fixed costs of $3,500,000

Learning objective 2: Perform cost-volume profit analysis for single and multiple products.


The 2,500 units is made up of the 2:1 mix, so Rohr must sell 1,667 Model A (2/3 of 2,500) and 833 Model B units (1/3 0f 2,500)



Contribution Margin Ratio Approach Products are substantially different

Calculate total company contribution margin ratio

Use total company contribution margin ratio to compute required sales in dollars Total company fixed costs (common costs) are

not included for contribution margin approach but used for contribution margin ratio approach



A company with 4 divisions has the following information available:

Total sales $6,450,000Total variable costs $4,706,000Total direct fixed costs $484,000Total common fixed costs $1,120,000

1. Calculate total contribution margin ratio($6,450,000 – $4,706,000) / $6,450,000 = .2704

2. Calculate total company break-even sales in dollars

($484,000 + $1,120,000) / .2704 = $5,931,953



Can calculate the contribution margin ratio for each product line Can also easily calculate the break-even point for

the various product lines Break-even sales for garden tools is $95,000 / .1874

= $506,937 When total company sales increase, each

product line’s sales will increase proportionately Can use the contribution margin ratio to calculate

the increase in profit for each product line


Assumptions in CVP AnalysisAssumptions in CVP Analysis

Assumptions can affect the validity of the analysis1. Costs can be separated into fixed and

variable components

2. Total fixed cost and unit variable cost do not change over the levels of interest

3. Multiproduct analysis assumes the product mix does not change

Despite assumptions, CVP is useful


Operating LeverageOperating Leverage

Level of fixed versus variable costs in a company

A company with a high level of fixed costs has a high operating leverage Companies with high operating leverage

have large fluctuations in profit when sales increase or decrease These companies are seen as more risky

High operating leverage is better when sales are expected to increase

Learning objective 3: Discuss the effect of operating leverage, and use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

Slide 4-62

ConstraintsConstraints

Due to shortages of space, equipment or labor there can be constraints on how many items can be produced

Utilize contribution margin per unit to analyze situations Calculate contribution margin per unit of

constraint Produce product with highest contribution

margin per unit of constraint Linear programming can solve multiple

constraints

Slide 4-63 Learning objective 3: Discuss the effect of operating leverage, and use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.


A company can produce Product A or Product B using the same machinery. Only 1,000 machine hours are available.

Slide 4-64Learning objective 3: Discuss the effect of operating leverage, and use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.


With the 1,000 available machine hours, Product A generates $20,000 of contribution

margin Product B generates $50,000 of contribution

margin Although Product A has the higher

contribution margin per unit, Product B has the higher contribution margin per unit of constraint

Slide 4-65Learning objective 3: Discuss the effect of operating leverage, and use the contribution margin per unit of the constraint to analyze situations involving a resource constraint.

CHAPTER 4CHAPTER 4

Cost-Volume-Profit Analysis Appendix

Cost-Volume-Profit Analysis Appendix

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CopyrightCopyright

© 2016 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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prepared by debby bloom-hill cma, cfm. cost-volume-profit analysis slide 4-2 chapter 4

Documents

cost increases

fixed coststotal fixed

highlow method

account analysis

learning objective

cakesif activity increases

variable costscosts

hourpredict labor costs