ACCT202

Chapter 4

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Chapter 4 Cost-Volume-Profit (CVP) Analysis

Some things we know:
The objective of every business is to make money (profit) for the owners Profit = Revenues Expenses Revenues = Sales = Quantity sold x price per unit Expenses = the costs related to: the specific revenue (COGS) or the specific accounting period Matching Principle Role of Management is: Planning, control and performance measurement, and decision-making Decision-making relates to future events and involves risk Full costing (full-absorption costing) is a good historical tool but may not Be the best indicator of future activity because it is based on past events.

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Cost Behavior
Variable Costs total dollars change with volume, Cost per unit is constant Fixed Costs total dollars are constant, cost per unit changes with volume Mixed Costs include some variable costs and some fixed costs Total Cost = Fixed Costs + Volume(variable cost per unit) Fixed Component $25,000 0 10,000 $35,000 Variable Component $ 0 5.00 per unit 2.00 per unit $7.00 per unit

Purely Fixed Purely Variable Mixed Costs Total Costs

Graphing Total Costs X axis (horizontal/across) = volume Y axis (vertical/up & down) = dollars

Estimating the Composition of Mixed Costs

Account Analysis Scattergraph Visual inspection of plotted points High-Low Estimation Theory: The change in total costs between the high volume point and The low volume point, must be purely variable costs Linear Regression (computer assisted scattergraph)

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Contribution Margin Income Statement

Ignores the function of the expenses Focus is on cost behavior (fixed and variable) Used extensively in forecasting future potential outcomes (planning & decision making) Because Profit = Revenue Expenses(Costs) Where: Revenue = Volume x price per unit And Total Costs = Fixed Cost + (Volume x Variable cost per unit) Therefore: Volume x price per unit Less Volume x variable cost per unit Less Fixed costs Profit Revenue Less Variable Costs CONTRIBUTION MARGIN Less Fixed Costs Pretax Profit KNOW THIS FORMULA FRONTWARDS AND BACKWARDS Margin of Safety = the difference between the expected level of volume and the breakeven point (normally using sales dollars but could also use units sold). When comparing two or more alternatives it may be helpful to look at the Margin of Safety as a percentage of sales. Contribution Margin Ratio = CM per unit / Selling Price per unit Or Contribution Margin / Sales Operating Leverage = Fixed Costs / Contribution Margin Or Contribution Margin/Pretax Profit

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Cost-Volume-Profit (CVP) Analysis

Break-Even Point = the point at which profit = zero (i.e. we break even) = The point at which Contribution Margin = Fixed Costs Once we know the break-even point, we can begin to plan for target profit Target Pre Tax Profit versus Target After Tax Profit Pretax Profit Less Tax Expense After Tax or Net Profit $100 40 $ 60

Effective Tax Rate = Tax Expense / Pretax Profit (40% above) Tax Expense = Pretax Profit x Effective Tax Rate Net Income = Pretax Profit x (1- effective tax rate) Pretax Profit = Net Profit / (1- effective tax rate)

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Multiple Product CVP Analysis

Weighted-Average Contribution Margin (also referred to as blended average) PRODUCT MIX IS CRITICAL Product 1 Units Sold 100 Selling Price $10.00 Variable Costs 5.00 Sales $1,000 Contribution Margin 500 CM Ratio 50% Product 2 20 $50.00 $30.00 $1,000 $ 400 40% Total

$2,000 900 45%

SO LONG AS THE PRODUCT MIX REMAINS AT 5:1 THE PROJECTED CM RATIO WILL STAY AT 45%. Therefore if sales are expected to be $20,000, AND WE SELL 5 of Product 1 for every 1 unit of Product 2, Contribution Margin should be $9,000 ($20,000 x 45%) However if sales of Product 1 are only $1,000 and the remaining $19,000 are sales of Product 2 the Contribution margin is only $8,100 and the CM Ratio drops to 40.5%. plus or $ 1,000 x 50% = $ 500 $19,000 x 40% = $7,600 $20,000 $8,100 = 40.5% of sales (1/20 x .50) + (19/20 x .40) .025 + .38 = 40.5%

When computing the Weighted-Average Contribution Margin USE SALES DOLLARS as the weighing factor (NOT UNITS).

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Constraint = a limitation of resources

To maximize profits given a limited resource, produce the product that generates the highest contribution margin per limited resource. This may not be the product with the highest contribution margin ratio. Illustration: A company manufactured two types of beer, premium and regular. Both types of beer are brewed in the same kettles. A regular batch brews for 15 days and yields 12,000 bottles. A premium batch brews for 30 days and yields 12,000 bottles. Regular beer sells for $1.00 per bottle and has variable costs of $0.40 per bottle. The premium sell for $1.50 per bottle and has variable costs of $0.50 per bottle. Assuming unlimited demand of both products, which product should the company brew? Premium Per Batch: Sales CM CM % $15,000 $12,000 66.67% Regular $12,000 $ 7,200 60.00% $ 7,200 15 $480

CM per Limited Resource (Days) CM $12,000 Divided by days 30 CM per day of limited Resource use $400

Regular beer has a higher CM per limited resource. Therefore, given unlimited demand of both types, produce only regular. Proof: In 30 days we can make one batch of premium, which will yield $12,000 in CM. In the same 30 days we can make 2 batches of regular, which will yield $14,400 in CM. We are in business to make money for the owners, not percentages. You cant deposit percentages in the bank!