Cost Volume Profit Analysis

Chapter 2
 Cost Behavior Analysis

High-Low Method
 Mixed costs must be classified into their fixed and
variable elements.

 High-Low Method uses the total costs incurred at both

the high and the low levels of activity to classify mixed
costs.

 The difference in costs between the high and low levels

represents variable costs, since only variable costs
change as activity levels change.
 Cost Behavior Analysis

High-Low Method
STEP 1: Determine variable cost per unit using the
following formula:
 Cost Behavior Analysis

High-Low Method
Illustration: Metro Transit Company has the following
maintenance costs and mileage data for its fleet of buses
over a 6-month period.

Change in Costs (63,000 - 30,000) $33,000 $1.10

= cost per
High minus Low (50,000 - 20,000) 30,000
unit
 Cost Behavior Analysis

High-Low Method
STEP 2: Determine the fixed cost by subtracting the total
variable cost at either the high or the low activity level from
the total cost at that level.
 Cost Behavior Analysis

High-Low Method
Maintenance costs are therefore $8,000 per month plus
$1.10 per mile. This is represented by the following formula:

Maintenance costs = Fixed costs + ($1.10 x Miles driven)

Example: At 45,000 miles, estimated maintenance costs

would be:
Fixed
Variable $ 8,000
($1.10 x 45,000)

49,500
$57,500
Cost Behavior Analysis
Scatter plot for Metro
Transit Company
Byrnes Company accumulates the following data concerning a
mixed cost, using units produced as the activity level.

(a) Compute the variable and fixed cost elements using the high-
low method.
(b) Estimate the total cost if the company produces 6,000 units.
 (a) Compute the variable and fixed cost elements using the high-
low method.

Variable cost: ($14,740 - $11,100) / (9,800 - 7,000) = $1.30 per unit

Fixed cost: $14,740 - $12,740 ($1.30 x 9,800 units) = $2,000
or $11,100 - $9,100 ($1.30 x 7,000) = $2,000
 (b) Estimate the total cost if the company produces 6,000 units.

Total cost (6,000 units): $2,000 + $7,800 ($1.30 x 6,000) = $9,800

 Cost-Volume-Profit Analysis

Cost-volume-profit (CVP) analysis is the study of the effects

of changes of costs and volume on a company’s profits.
 Important in profit planning

 Critical factor in management decisions as

► Setting selling prices,

► Determining product mix, and

► Maximizing use of production facilities.

 Cost-Volume-Profit Analysis

Basic Components
Illustration 5-9
 Cost-Volume-Profit Analysis

Basic Components - Assumptions

 Behavior of both costs and revenues is linear throughout
the relevant range of the activity index.

 All costs can be classified as either variable or fixed with

reasonable accuracy.

 Changes in activity are the only factors that affect costs.

 All units produced are sold.

 When more than one type of product is sold, the sales

mix will remain constant.
 Cost-Volume-Profit Analysis

CVP Income Statement

 A statement for internal use.
 Classifies costs and expenses as fixed or variable.
 Reports contribution margin in the body of the
statement.
► Contribution margin – amount of revenue
remaining after deducting variable costs.

 Reports the same net income as a traditional income

statement.
 Cost-Volume-Profit Analysis

CVP Income Statement

Illustration: Vargo Video produces a high-definition digital
camcorder with 15x optical zoom and a wide-screen, high-
resolution LCD monitor. Relevant data for the camcorders
sold by this company in June 2014 are as follows.
 Cost-Volume-Profit Analysis

CVP Income Statement

Illustration: The CVP income statement for Vargo Video
therefore would be reported as follows.
 Cost-Volume-Profit Analysis

Contribution Margin per Unit

 Contribution margin is available to cover fixed costs
and to contribute to income.
 Formula for contribution margin per unit and the
computation for Vargo Video are:
 Cost-Volume-Profit Analysis

Contribution Margin per Unit

Vargo’s CVP income statement assuming a zero net income.
 Cost-Volume-Profit Analysis

Contribution Margin per Unit

Assume that Vargo sold one more camcorder, for a total of
1,001 camcorders sold.
 Cost-Volume-Profit Analysis

Contribution Margin Ratio

 Shows the percentage of each sales dollar available
to apply toward fixed costs and profits.
 Formula for contribution margin ratio and the
computation for Vargo Video are:
 Cost-Volume-Profit Analysis

Contribution Margin Ratio

Assume current sales are $500,000, what is the effect of a
$100,000 (200-unit) increase in sales?
 Cost-Volume-Profit Analysis

Contribution Margin Ratio

Assume Vargo Video’s current sales are $500,000 and it wants
to know the effect of a $100,000 (200-unit) increase in sales.

Illustration 5-18
 Cost-Volume-Profit Analysis

Break-Even Analysis
 Process of finding the break-even point level of activity
at which total revenues equal total costs (both fixed
and variable).
 Can be computed or derived
► from a mathematical equation,
► by using contribution margin, or
► from a cost-volume profit (CVP) graph.

 Expressed either in sales units or in sales dollars.

 Break-Even Analysis

Mathematical Equation
Break-even occurs where total sales equal variable costs plus
fixed costs; i.e., net income is zero

Computation
of break-even
point in units.
 Break-Even Analysis

Contribution Margin Technique

 At the break-even point, contribution margin must equal
total fixed costs

(CM = total revenues – variable costs)

 Break-even point can be computed using either
contribution margin per unit or contribution margin ratio.
 Break-Even Analysis

Contribution Margin Technique

 When the BEP in units is desired, contribution margin
per unit is used in the following formula which shows
the computation for Vargo Video:
 Break-Even Analysis

Contribution Margin Technique

 When the BEP in dollars is desired, contribution
margin ratio is used in the following formula which
shows the computation for Vargo Video:
 Break-Even Analysis

Graphic
Presentation
Because this graph
also shows costs,
volume, and profits, it
is referred to as a
cost-volume-profit
(CVP) graph.
Lombardi Company has a unit selling price of $400, variable
costs per unit of $240, and fixed costs of $180,000. Compute
the break-even point in units using (a) a mathematical
equation and (b) contribution margin per unit.
Illustration 5-19

Sales Variable Fixed Net

- - =
Costs Costs Income

$400Q - $240Q - $180,000 = 0

$160Q - $180,000
Q = 1,125 units
Lombardi Company has a unit selling price of $400, variable
costs per unit of $240, and fixed costs of $180,000. Compute
the break-even point in units using (a) a mathematical
equation and (b) contribution margin per unit.

Fixed Contribution Break-Even

÷ =
Costs Margin per Unit Point in Units

$180,000 ÷ $160 = 1,125 units

 Cost-Volume-Profit Analysis

Target Net Income

 Level of sales necessary to achieve a specified
income.
 Can be determined from each of the approaches used
to determine break-even sales/units:
► from a mathematical equation,
► by using contribution margin, or
► from a cost-volume profit (CVP) graph.

 Expressed either in sales units or in sales dollars.

 Cost-Volume-Profit Analysis

Target Net Income

Sales necessary to achieve a specified level of income.

Mathematical Equation
Formula for required sales to meet target net income.
 Target Net Income

Mathematical Equation
Using the formula for the break-even point, simply include
the desired net income as a factor.
 Target Net Income

Contribution Margin Technique

To determine the required sales in units for Vargo Video:
 Target Net Income

Contribution Margin Technique

To determine the required sales in dollars for Vargo Video:
 Cost-Volume-Profit Analysis

Margin of Safety
 Difference between actual or expected sales and sales
at the break-even point.
 Measures the “cushion” that management has if expected
sales fail to materialize.
 May be expressed in dollars or as a ratio.
 Assuming actual/expected sales are $750,000:
 Cost-Volume-Profit Analysis

Margin of Safety
 Computed by dividing the margin of safety in dollars by
the actual or expected sales.
 Assuming actual/expected sales are $750,000:
Illustration 5-29

 The higher the dollars or percentage, the greater the

margin of safety.
Zootsuit Inc. makes travel bags that sell for $56 each. For the
coming year, management expects fixed costs to total
$320,000 and variable costs to be $42 per unit. Compute the
following: (a) break-even point in dollars using the contribution
margin (CM) ratio; (b) the margin of safety assuming actual
sales are $1,382,400; and (c) the sales dollars required to earn
net income of $410,000.
Compute: (a) break-even point in dollars using the
contribution margin (CM) ratio.

Unit selling price $56

Unit variable costs - 42
Contribution margin per unit 14
Unit selling price 56
Contribution margin ratio 25%

Fixed costs $320,000

Contribution margin ratio 25%
Break-even sales in dollars $1,280,000
Compute: (b) the margin of safety assuming actual sales are
$1,382,400.

Actual (Expected) sales $ 1,382,400

Break-even sales - 1,280,000
Margin of safety in dollars 102,400
Actual (Expected) sales 1,382,400
Margin of safety ratio 7.4%
Compute: (c) the sales dollars required to earn net income
of $410,000.

Fixed costs $ 320,000

Target net income + 410,000
730,000
Contribution margin ratio 25%
Required sales in dollars $2,920,000
CVP and Changes in the Business Environment
To better understand CVP analysis, three
independent cases involving Vargo will be examined.
Each case will use the original data for Vargo Video:

Basic Data
 Case
Case II

Should Vargo Video match a competitor’s 10% discount

and reduce selling price to $450 per unit?
News Sales Price [$500 - (.10 × $500)] = $450.
New Contribution Margin ($450 - $300) = $150.
 Case
Case II

Should Vargo Video match a competitor’s 10% discount

and reduce selling price to $450 per unit?
Management must decide how likely it is that Vargo
can achieve the increase in sales as well as the
likelihood of lost sales if the discount is not matched.
 Case
Case II
II

Use of new equipment is being considered that will

increase fixed costs by 30% and lower variable
costs by 30%. What effect will the new equipment
have on the sales required to break-even?
Fixed costs will increase $60,000 and variable costs
will decrease $90,000 (variable cost per unit = $210).
 Case
Case II
II

Fixed costs will increase $60,000 and variable costs

will decrease $90,000 (variable cost per unit = $210).

The change appears positive as break-even point is

reduced by approximately 10%.
 Case
Case III
III

Vargo’s supplier of raw materials has increased the

cost of raw materials which will increase the variable
cost per unit by $25 to $325.
The selling price will remain the same at $500.
New contribution margin $175 ($500 - $325).
Management intends to cut fixed costs by $17,500 to
$ 182,500.
 Case
Case III
III

Vargo currently has a net income of $80,000 on sales

of 1,400 DVDs.
How many more units will need to be sold to maintain
the $80,000 net income?
 Case
Case III
III
Variable cost per unit increases to $325 as a result of
the $25 increase in raw materials cost.

Fixed costs decrease to $182,500.

Contribution margin per unit is now $175.

If Vargo cannot sell an additional 100 units,

management must further reduce costs, increase the
selling price of the DVDs, or accept a lower net income.
 Sales
Sales Mix
Mix

When a company sells more than one product:

It is important to understand
its sales mix.
The sales mix is the relative percentage in which a
company sells its products.
If a company’s unit sales are 80%
printers and 20% computers, its
sales mix is 80% to 20%.
Sales mix is important because
different products often have very
different contribution margins.
 Break-Even
Break-Even Sales
Sales in
in Units
Units
A company can compute break-even sales
for a mix of two or more products by
determining the:
Weighted-average unit
contribution margin of all products.

The weighted-average unit contribution

margin is the sum of the weighted
contribution margin of each product.

5-72
 Break-Even
Break-Even Sales
Sales in
in Units
Units -- Example
Example

Assume that Vargo Video sells two products and has the
following sales mix and related information:

5-73
 Break-Even
Break-Even Sales
Sales in
in Units
Units -- Example
Example
First, determine the weighted-average contribution
margin for Vargo’s two products:

Second, use the weighted-average unit contribution

margin to compute the break-even point in units:

5-74
 Break-Even
Break-Even Sales
Sales in
in Units
Units -- Example
Example
With a break-even point of 1,000 units, Vargo must
sell:
750 DVD Players (1,000 units × 75%)
250 TVs (1,000 units × 25%)

At this level, the total contribution margin will equal

the fixed costs of $275,000 .
 Break-Even
Break-Even Sales
Sales in
in Dollars
Dollars
The calculation of break-even point in units works
well if the company has only a few products.

Consider 3M which has over 30,000 different

products:
3M would need to calculate 30,000 different
unit contribution margins.

When there are many products, calculate the break-

even point in terms of sales dollars for divisions or
product lines, NOT individual products.
Break-Even
Break-Even Sales
Sales in
in Dollars
Dollars -- Example
Example

Assume that Kale Garden Supply Company has two

divisions: Indoor Plants and Outdoor Plants.

Each division has hundreds of different plant

types.

Compute sales mix as a percentage of total dollar

sales rather than units sold,
and
Compute the contribution margin ratio rather than
the contribution margin per unit.
Break-Even
Break-Even Sales
Sales in
in Dollars
Dollars -- Example
Example

The information necessary to perform cost-

volume-profit analysis is:
 Break-Even
Break-Even Sales
Sales in
in Dollars
Dollars -- Example
Example
First, determine the weighted-average contribution
margin ratio for each division:

Second, use the weighted-average unit contribution

margin ratio to compute the break-even point in
dollars:

5-79
 Break-Even
Break-Even Sales
Sales in
in Dollars
Dollars -- Example
Example
With break-even sales of $937,500 and a sales mix
of 20% to 80%, Kale must sell:
$187,500 from the Indoor Plant division.
$750,000 from the Outdoor Plant division.
If the sales mix between the divisions changes, the
weighted-average contribution margin ratio also
changes, resulting in a new break-even point in
dollars.
 Sales
Sales Mix
Mix with
with Limited
Limited Resources
Resources

All companies have limited resources whether it be

floor space, raw materials, direct labor hours, etc.
Limited resources force management to decide which
products to sell to maximize net income.
Example: Vargo makes DVD players and TVs. The
limiting resource is machine capacity – 3,600 hours per
month. Relevant date is as follows:
Sales
Sales Mix
Mix with
with Limited
Limited Resources
Resources -- Example
Example
The TVs seem to be more profitable since they have the
higher contribution margin per unit, but they require
more machine hours to produce than the DVD Players.
To determine the appropriate sales mix, compute the
contribution margin per unit of limited resource:

Since DVD players have higher contribution margin per

machine hour, management should produce more DVD
players if demand exists or else increase machine
capacity.
 Sales
SalesMix
Mixwith
withLimited
LimitedResources
Resources--Example
Example

Alternative: Increase machine capacity from

3,600 to 4,200 hours.

Illustration 19-20

To maximize net income, all 600 hours should be

used to produce and sell DVD players.
 Let’s
Let’s Review
Review
If the contribution margin per unit is $15 and it takes
3.0 machine hours to produce the unit, the contribution
margin per unit of limited resource is:

a. $25.
$25
b. $5.
c. $4.
d. No correct answer is given.

$15 ÷ 3 hours = $5 an hour

Cost
Cost Structure
Structure and
and Operating
Operating Leverage
Leverage

Cost Structure is the relative proportion of

fixed versus variable costs that a company incurs.
May have a significant effect on profitability.
Thus, a company must carefully choose its cost
structure.
 Comparison
Comparison of
of Cost
Cost Structures
Structures
Vargo Video manufactures DVD players using a traditional,
labor-intensive manufacturing process.
New Wave Company also manufactures DVD players, but uses a
completely automated system where factory employees only set
up, adjust, and maintain the machinery.

Illustration 19-21
Both companies have the same sales and net income; however,
each has different risks and rewards due to changes in sales as
a result of their cost structures.

5-86
 Effect
Effect on
on Contribution
Contribution Margin
Margin Ratio
Ratio

The contribution margin ratio for each company is as follows:

Thus, New Wave contributes 80 cents to net income for each

dollar of increased sales while Vargo only contributes 40 cents.
However, New Wave loses 80 cents per dollar of sales
decrease while Vargo only loses 40 cents.
New Wave’s cost structure which relies on fixed costs is more
sensitive to changes in sales.

5-87
 Effect
Effect on
on Break-even
Break-even Point
Point

The break-even point for each company is as follows:

New Wave needs to generate $150,000 more in sales than

Vargo to break-even.
Because of the greater break-even sales required, New Wave is
a riskier company than Vargo.
 Effect
Effect on
on Margin
Margin of
of Safety
Safety Ratio
Ratio

The margin of safety ratio of each company is as follows:

The difference in the margin of safety ratio reflects the

difference in risk between New Wave and Vargo.
Vargo can sustain a 38% decline in sales before operating at a
loss versus only a 19% decline for New Wave before it would be
operating “in the red.”
 Operating
Operating Leverage
Leverage
Operating leverage refers to the extent that net
income reacts to a given change in sales.

Higher fixed costs relative to variable costs cause a

company to have higher operating leverage.

When sales revenues are increasing, high operating

leverage means that profits will increase rapidly – a good
thing.

When sales revenues are declining, too much operating

leverage can have devastating consequences.
 Operating
Operating Leverage
Leverage
The degree of operating leverage provides a measure
of a company’s earnings volatility.
The degree of operating leverage is computed by
dividing total contribution margin by net income.
The computations for Vargo and New Wave are:

New Wave’s earnings would go up (or down) by about

two times (5.33 ÷ 2.67 = 1.99) as much as Vargo’s
with an equal increase in sales.
 Chapter
Chapter Review
Review -- Brief
Brief Exercise
Exercise
Briggs Candle Supply makes candles. The sales mix (as
a percent of total dollar sales) of its three product
lines is as follows: birthday candles, 30%; standard
tapered candles, 50%; and large scented candles,
20%. The contribution margin ratio of each candle
type is shown below.

Candle Type Contribution Margin Ratio

Birthday 10%
Standard tapered 20%
Large scented 45%

What is the weighted-average contribution margin

ratio?
 Chapter
Chapter Review
Review -- Brief
Brief Exercise
Exercise
Type of Candles CMR Sales Mix
Birthday 10% × 30% = 3%
Standard tapered 20% × 50% = 10%
Large scented 45% × 20% = 9%
Weighted Average Contribution Margin Ratio 22%

If the company’s fixed costs are $440,000 per year, what is the
dollar amount of each type of candle that must be sold to break
even?

Step 1: Fixed Costs:

$440,000 ÷ WACMR 22% = $ BEP = $2,000,000

Step 2:
Birthday candles $2,000,000 × 30% = $ 600,000
Standard tapered $2,000,000 × 50% = 1,000,000
Large scented $2,000,000 × 20% = 400,000
$2,000,000
End of chapter two
Thank you