11/25/2010

Week Seven

C-V-P Analysis

Cost-Volume-Profit Analysis
 CVP analysis is a method for analyzing how operating
decisions and marketing decisions affect profit

 Managers use CVP analysis to guide strategic decision

 e.g. a decision about which feature to add to an existing
product; how much to advertise, whether to expand into
new markets, and how to price the product.

 These decision can affect SP, VC, FC units sold and OI

 CVP analysis helps managers in making decision by

estimating the expected profitability of the choices
Q. What are the assumption of C-V-P analysis

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CVP analysis can be used in:

– Setting prices for products and services

– Determining whether to introduce a new product or
service
– Replacing a piece of equipment
– Determining breakeven point
– Making “Make-or-buy” (i.e., sourcing) decisions
– Determining the best product mix
– Performing strategic “what-if” (sensitivity) analysis

Strategic Role of CVP Analysis

CVP analysis can help a firm choose its strategic position

and execute its strategy by providing an understanding of
how changes in sales volume affect costs and profits

 This process is most important for cost leadership firms

during the manufacturing stage

 Differentiation firms use CVP analysis to assess

profitability and desirability of new products and features

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CVP analysis is also important in life-cycle costing and target

costing

 CVP analysis can assist in life-cycle costing by helping to

determine whether a product is likely to achieve its desired
profitability, the most cost-effective manufacturing process,
the best marketing and distribution channels, the best
compensation plan, whether to offer discounts, etc.

 CVP analysis can assist in target costing by showing the

effect on profit of alternative product designs that have
different target costs

Break-Even Analysis – A quick

Review
 Break-even analysis can be approached in two ways:
1. Equation method
2. Contribution margin method

 Equation Method:
Profit/Operating Income (OI) = Sales revenue – VC – FC
OR
OI = [(SP x Q sold) – ( VCPU x Q sold) – FC
 Contribution Margin Method
Break-even point Fixed expenses
in units sold = Unit contribution margin
Break-even point in Fixed expenses
total sales dollars =
CM ratio

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Profit Targets and Sales Revenue

 The equation and contribution margin methods can be used
to determine the sales volume needed to achieve a target
profit.
 i.e. how many units must be sold to earn a certain amount
of operating income.

 Using equation method-

 To calculate revenues needed to earn a certain amount
of operating income -

Sales = Variable expenses + Fixed expenses + Profits

 Using contribution margin method

 To calculate the quantity must be sold to earn a target profit

Unit sales to attain Fixed expenses + Target profit

=
the target profit Unit contribution margin

OR
Q = [ (FC + TP) / CMPU ]
 To calculate revenues needed to earn a certain amount of
operating income
Unit sales to attain Fixed expenses + Target profit
=
the target profit Contribution margin ratio
OR
Revenues = [ (FC + TP) / CM% ]

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Risk and Uncertainty in Decision

Making

 Strategic decisions invariably involve risk and uncertainty

 Risk differ from uncertainty.

 Under risk the probability distribution of variables are
known, whereas, under uncertainty they are not known.

 Q. What are the concepts managers apply to deal with risk

and uncertainty in the context of CVP?

Margin of safety (MS)

 Is the unit sold (revenue earned) or expected to be sold
(revenue expected to be earned) above the break-even
volume.
MS in unit = (Sales in unit – BEP in unit)

 It is a crude measures of risk

 because there are unknown events that can lower
sales below the expected level.

 It states the amount by which sales can drop before

losses begin to incurred

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Operating Leverage (OL):

 Operating leverage provides information concerning the
relationship between a company’s variable and fixed costs.

 Give indication how sensitive net income is to percentage

change in sales.

 OL act as multiplier

 Generally, companies that are highly labor intensive tend to

have higher variable costs and lower fixed costs, and thus,
low operating leverage. The reverse is also true for capital
intensive companies.

Degree of OL = CM / Profit

 A higher DOL value indicates a higher risk in the sense

that a given change in sales will have a relatively greater
% impact on profits

 Firms with a higher OL will experience greater reductions

in profits as sales decrease.

 The DOL can be thought of as the extent to which fixed

costs characterize the cost structure of an organization:
 the higher the percentage of fixed costs, the higher the
DOL (and therefore the higher the operating risk)

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 Characteristics of a highly leveraged company

 Generally have high contribution margin since their

variable costs tend to be lower. However, the higher fixed
costs would mean that the BEP would also be high.

 If selling price is relatively stable, the volume of sales

would have high impact on profit/loss. A small increase in
sales volume can have a major impact on profit/loss within
a given relevant range.

 It is important to reduce operational leverage during

periods of economic distress

Example: Assume following information is gathered from

Bicycle division of Racing Bicycle company.
Actual sales
500 Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income $ 20,000

At Racing Bicycle co., the degree of

$100,000 = 5
operating leverage is =
$20,000

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 If sales are higher (in certain percentage) then the

expected/projected sales, then it has effect on the percentage
change in profits.
% change in profits = DOL x % change in sales
For example- with an operating leverage of 5, if Racing increases
its sales by 10%, net operating income would increase by 50%.

Percent increase in sales 10%

Degree of operating leverage × 5
Here’s the verification!
Percent increase in profits 50%

Actual sales Increased

(500) sales (550)
Sales $ 250,000 $ 275,000
Less variable expenses 150,000 165,000
Contribution margin 100,000 110,000
Less fixed expenses 80,000 80,000
Net operating income $ 20,000 $ 30,000

10% increase in sales from

$250,000 to $275,000 . . .
. . . results in a 50% increase in
income from $20,000 to $30,000.

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Sensitivity Analysis
 Sensitivity analysis is a “what-if” technique that manager use to
examine-
 how a result will change if the original predicted data are not
achieved (due to uncertainty) or if an underlying assumption
changes.
 Therefore, this analysis is the calculation of an amount given
different levels of a factor that influences that amount
 In the context of CVP analysis, sensitivity analysis answer such
question as-
 What will operating income be if the units sold decreased say by
5% from the originally predicted?
 What will operating income be if variable cost per unit increase
say by 10% from the originally predicted?

Multiple Product CVP Analysis

 What is multiple product CVP Analysis?
 method for analyzing how operating decisions and
marketing decisions affect profit when company sell
multiple products

 Assumptions required:
• Sales mix (i.e. ratio of products sold) is assumed constant
• Fixed costs is not directly related to a particular product.

 Basic approach to deal with multi-product situation is -

 Determine the Total Sales dollars and Total quantity of
units to be sold as well as the Sales and Units Sales of
the individual products

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Setting up the problem

 The challenge of Multiple product CVP analysis is diminished

when you set up the problem correctly.
 Create CM income statement for each product
 Create a total column that is a summation of the different
products

Example: Setting up the problem

 Assume that a company sells two products: Product A and
Product B. The sales prices are $10 for product A and $15
for product B. Variable costs per unit are $8 for Product A
and $9 for Product B. The company has total fixed costs of
$5,000. Assume the company expects to sell 1,500 units of
Product A and 500 units of Product B.

UNITS 1,500 500 2,000

Product A Product B TOTAL

Sales $ 15,000 $ 7,500 $ 22,500

Variable costs $ (12,000) $ (4,500) $ (16,500)

Contribution Margin $ 3,000 $ 3,000 $ 6,000

Fixed Costs $ (5,000)

Net Income $ 1,000

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Weighted Average CM and CM%

Weighted Average CM
 Take the Total CM from total column ($6,000 in example) and
divide by total units (2,000 in example).
 In example this gives a Weighted Average CM of $3 per unit.
UNITS 1,500 500 2,000

Product A Product B TOTAL

Sales $ 15,000 $ 7,500 $ 22,500
Variable costs $ (12,000) $ (4,500) $ (16,500)

Contribution Margin $ 3,000 $ 3,000 $ 6,000

Fixed Costs $ (5,000)

Weighted Average CM is
Net Income $6,000/2,000 units = $3/unit $ 1,000

Weighted Average CM%

 Take the CM from the TOTAL column ($6,000 in example) and
divide by the Sales from the total column ($22,500 in example).
 $6,000 / $22,500 = 26.67% (.2667)
UNITS 1,500 500 2,000

Product A Product B TOTAL

Sales $ 15,000 $ 7,500 $ 22,500
Variable costs $ (12,000) $ (4,500) $ (16,500)

Contribution Margin $ 3,000 $ 3,000 $ 6,000

Fixed Costs $ (5,000)

Weighted Average CM%

Net Income
$6,000 / $22,500 = 26.67% $ 1,000

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Calculating the Breakeven Point in Units

 Use the formula you already know, but use weighted average
CM:
 Breakeven units = (FC + Targeted Profit) / Wt. avg. CM
 This gives the TOTAL number of units to be sold at the breakeven
point. Then determine how many of Product A and Product B will be
sold at the breakeven point.
UNITS 1,500 500 2,000

Product A Product B TOTAL

Sales $ 15,000 $ 7,500 $ 22,500
Variable costs $ (12,000) $ (4,500) $ (16,500)

Contribution Margin $ 3,000 $ 3,000 $ 6,000

Fixed Costs $ (5,000)

Breakeven Units:

Net Income (5000 + 0) / 3 = 1,667 (rounded) $ 1,000

The Allocation to Determine Units of Each

Product Sold at the Breakeven Point
Allocate Total Units to each product Based on Expected
Units Proportion
 Must assume that the company will continue to sell the products
in fixed proportions.
 In this example company sell 1,500 units of Product A and 500
units of Product B.
 So the proportion of units of Product A is 1,500/2,000 and the
proportion of units of Product B is 500/2,000.
 Take the total units to be sold at the breakeven point (1,667)
and multiply by each product’s proportion

 PRODUCT A: 1,667 * (1,500/2,000) = 1250 units

 PRODUCT B: 1,667 * (500/2,000) = 417 units

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Calculating the Breakeven Point in

Sales Dollars
 Can be determined the breakeven point in Sales Dollars two
ways:
1. Calculate the Breakeven point in units and then multiply by the
sales price per unit
2. Using the CM % method, directly calculate the Breakeven Point in
Sales Dollars

Multiply Breakeven Units by the sales price per unit

 We know that the company will sell 1,250 units of Product A and 417
units of Product B. Therefore,
 Breakeven Sales Dollars of Product A:
 1,250 * $10 per unit = $12,500
 Breakeven Sales Dollars of Product B:
 417 * $15 per unit = $6,255

Directly Calculate the Breakeven Sales Dollars Using CM %

 Using the data from the Total column the Contribution Margin %
is 26.67%.
 Using the Breakeven formula -determine the breakeven sales
dollars for the company as a whole: (FC + Targeted Profit)/CM%
($5,000+0) / 26.67% = $18,748

 Now allocation percentages of Sales Dollars for the individual

products (based on given sales data) and Calculate Sales
Dollars using Proportions:
Product A: $18,748 * ($15,000 / $22,500) = $12,499
Product B: $18,748 * ($7,500 / $22,500) = $6,249

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Alternative Way to Deal with

Multiple-Product CVP Analysis

 Alternative approach to deal with multiple products situation

is-
 Convert the multi-product problem into a single-product
problem i.e.
 identify the expected sales mix (in units) of the products.

 Sales mix is the relative proportion in which a company’s

products are sold.
 Different products have different selling prices, cost
structures, and contribution margins.

 Determining sales Mix:

 Can be measured in unit sold or in proportion of revenue.
But for CVP analysis, better to use sales mix expressed in
units.
 e.g. say, sales mix of product X and Y is 3:2 which
means that it is expected to sell 3 units of X for ever 2
units of Y.
 After determining sales mix, firm can define the product it sell
as package containing units X and Y.
 By defining the product as package multiple product problem
is converted into single product

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 Now next step is to determine package contribution margin

to calculate package BEP in units.
 to calculate this the sales mix, individual product price
and variable cost are needed.

 Therefore,
BE package = FC / Package contribution Margin

 Limitation of the approach:

 Complexity of the approach increase when the number
of product increases

 ABC co. Produces and sells three types of yoga-training

products: Video tapes, Basic equipment set and Yoga Mat. Last
year Co. Sold 10,000 videos; 5,000 equipment sets and yoga
mats 20,000. Information on the three products is as follows:
Video Equipment Set Yoga Mat

Price $ 12.00 $ 15.00 $18

Variable cost per 4.00 6.00 $13

unit
 Total fixed costs are $118,350
Required:
 What is the sales mix of videos, equipment sets and yoga mats?
 Calculate the BEQ of each product

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Multiple-Product Break- Even

Analysis – Example 11.9
 Solution: R- 1 & 2
Product Selling VC CM Sales Mix Total CM
price
Videos $12 $4 $8 2 $16

Equip Sets 15 6 9 1 9

Yoga Mats 18 13 5 4 20

BE package ($118,350/$45) = 2,630

BE videos 2 x 2,630 = 5,260

Be Equip Sets 1 x 2,630 = 2,630

BE Yoga Mats 4 x 2,630 = 10,520

Conventional CVP Analysis and

Activity-Based Costing (ABC)
 Major limitation of traditional CVP
 Exclusive use of unit level activity cost drivers, i.e. does not
consider other categories of cost drivers
 High probability of significant errors in cost estimation and
prediction

 ABC-costs are divided into units and non-units based

categories

 Therefore Activity based CVP is the expansion of

conventional CVP approach to incorporate non-unit activity
cost drivers
 Difficult to develop graphical relationships
 Good way to begin is to make use of a contribution statement
that incorporates a hierarchy of cost drivers

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 Note that :
 If the assumption is made that say, total batch-level costs
are fixed relative to the number of batches, both
approaches will produce the same result

 On the other hand, if the activity cost pool is a mixed cost,

the ABC approach will provide a more accurate estimate of
cost because the traditional CVP approach treats all
activity costs that do not vary with output volume, (such as
machine setup, materials handling, inspection, and
engineering, as fixed)

CVP Analysis in Service and Non-

profit Organisations
 To apply CVP analysis in service and nonprofit
organisation-
 need to focus on measuring their output, which is
different from the tangible units sold.

 Example of output measures in various service and nonprofit

industries:
Industry Measure of Output
Airlines Passenger miles
Hotels/motels Room-nights occupied
Hospitals Patient days
Universities Student credit-hours

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