Chapter 7

Cost-VolumeProfit Analysis

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

The Break-Even Point

The break-even point is the point in the volume of activity where the organizations revenues and expenses are equal.
Sales $ 250,000 Less: variable expenses 150,000 Contribution margin 100,000 Less: fixed expenses 100,000 Net income $ -

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Equation Approach
Sales revenue Variable expenses Fixed expenses = Profit

Unit Sales sales volume price in units

Unit Sales variable volume expense in units

($500 X)

($300 X)

$80,000 = $0

($200X) $80,000 = $0

X = 400 surf boards

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Contribution-Margin Approach
Consider the following information developed by the accountant at Curl, Inc.:
For each additional surf board sold, Curl generates $200 in contribution margin.

Sales (500 surf boards) Less: variable expenses Contribution margin Less: fixed expenses Net income

Total $250,000 150,000 $100,000 80,000 $ 20,000

Per Unit $ 500 300 $ 200

Percent 100% 60% 40%

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Contribution-Margin Approach
Fixed expenses Break-even point = Unit contribution margin (in units)
Sales (500 surf boards) Less: variable expenses Contribution margin Less: fixed expenses Net income Total $250,000 150,000 $100,000 80,000 $ 20,000 Per Unit $ 500 300 $ 200 Percent 100% 60% 40%

$80,000 $200

= 400 surf boards

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Contribution-Margin Approach
Here is the proof!
Total $200,000 120,000 $ 80,000 80,000 $ Per Unit $ 500 300 $ 200 Percent 100% 60% 40%

Sales (400 surf boards) Less: variable expenses Contribution margin Less: fixed expenses Net income

400 $500 = $200,000

400 $300 = $120,000

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Contribution Margin Ratio

Calculate the break-even point in sales dollars rather than units by using the contribution margin ratio.

Contribution margin Sales Fixed expense CM Ratio

= CM Ratio

Break-even point = (in sales dollars)

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Contribution Margin Ratio

Sales (400 surf boards) Less: variable expenses Contribution margin Less: fixed expenses Net income

Total $200,000 120,000 $ 80,000 80,000 $ -

Per Unit $ 500 300 $ 200

Percent 100% 60% 40%

$80,000 40%

$200,000 sales
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Graphing Cost-Volume-Profit Relationships

Viewing CVP relationships in a graph gives managers a perspective that can be obtained in no other way. Consider the following information for Curl, Inc.:
300 units Sales $ 150,000 Less: variable expenses 90,000 Contribution margin $ 60,000 Less: fixed expenses 80,000 Net income (loss) $ (20,000) 400 units $ 200,000 120,000 $ 80,000 80,000 $ 500 units $ 250,000 150,000 $ 100,000 80,000 $ 20,000
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Cost-Volume-Profit Graph
450,000 400,000 350,000 300,000

Dollars

250,000 200,000 150,000 100,000 50,000

Fixed expenses

100

200

300

400 Units

500

600

700

800

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Cost-Volume-Profit Graph
450,000 400,000 350,000 300,000

Dollars

250,000 200,000 150,000 100,000 50,000

Fixed expenses

100

200

300

400 Units

500

600

700

800

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Cost-Volume-Profit Graph
450,000 400,000 350,000 300,000

Dollars

250,000 200,000 150,000 100,000 50,000

Fixed expenses

100

200

300

400 Units

500

600

700

800

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Cost-Volume-Profit Graph
450,000 400,000 350,000 300,000

Dollars

250,000 200,000 150,000 100,000 50,000

Fixed expenses

100

200

300

400 Units

500

600

700

800

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Cost-Volume-Profit Graph
450,000 400,000 350,000 300,000

Break-even point

Dollars

250,000 200,000 150,000 100,000 50,000

Fixed expenses

100

200

300

400 Units

500

600

700

800

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Profit-Volume Graph
Some managers like the profit-volume graph because it focuses on profits and volume.
100,000 80,000 60,000 40,000

Break-even point
` 100 200 300 400 Units 500 600 700

Profit

20,000 0 (20,000) (40,000) (60,000)

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Target Net Profit

We can determine the number of surfboards that Curl must sell to earn a profit of $100,000 using the contribution margin approach.
Fixed expenses + Target profit Unit contribution margin Units sold to earn the target profit

$80,000 + $100,000 $200

= 900 surf boards

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Equation Approach
Sales revenue Variable expenses Fixed expenses = Profit ($500 X) ($300 X) $80,000 = $100,000 ($200X) = $180,000 X = 900 surf boards
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Effect of Income Taxes

Income taxes affect a companys CVP relationships. To earn a particular after-tax net income, a greater before-tax income will be required.

Before-tax Target after-tax net income = net income 1 - t

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Applying CVP Analysis

Safety Margin
The difference between budgeted sales revenue and break-even sales revenue. The amount by which sales can drop before losses begin to be incurred.

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Safety Margin
Curl, Inc. has a break-even point of $200,000. If actual sales are $250,000, the safety margin is $50,000 or 100 surf boards.
Break-even sales 400 units $ 200,000 120,000 80,000 80,000 $ -

Sales Less: variable expenses Contribution margin Less: fixed expenses Net income

Actual sales 500 units $ 250,000 150,000 100,000 80,000 $ 20,000

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Changes in Fixed Costs

Curl is currently selling 500 surfboards per year. The owner believes that an increase of $10,000 in the annual advertising budget, would increase sales to 540 units. Should the company increase the advertising budget?
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Changes in Fixed Costs

Current Sales (500 Boards) Sales $ 250,000 Less: variable expenses 150,000 Contribution margin $ 100,000 Less: fixed expenses 80,000 Net income $ 20,000 Proposed Sales (540 Boards) $ 270,000 162,000 $ 108,000 90,000 $ 18,000

540 units $500 per unit = $270,000 $80,000 + $10,000 advertising = $90,000
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Changes in Fixed Costs

Current Sales will increase by Sales $20,000, but net income (500 Boards) decreased by $2,000. Sales $ 250,000 Less: variable expenses 150,000 Contribution margin $ 100,000 Less: fixed expenses 80,000 Net income $ 20,000 Proposed Sales (540 Boards) $ 270,000 162,000 $ 108,000 90,000 $ 18,000

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Changes in Unit Contribution Margin

Because of increases in cost of raw materials, Curls variable cost per unit has increased from $300 to $310 per surfboard. With no change in selling price per unit, what will be the new break-even point? ($500 X) ($310 X) $80,000 = $0 X = 422 units (rounded)
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Changes in Unit Contribution Margin

Suppose Curl, Inc. increases the price of each surfboard to $550. With no change in variable cost per unit, what will be the new break-even point?
($550 X) ($300 X) $80,000 = $0 X = 320 units
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CVP Analysis with Multiple Products

For a company with more than one product, sales mix is the relative combination in which a companys products are sold. Different products have different selling prices, cost structures, and contribution margins.

Lets assume Curl sells surfboards and sail boards and see how we deal with breakeven analysis.
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CVP Analysis with Multiple Products

Curl provides us with the following information: Unit Unit Number
Description Surfboards Sailboards Total sold Selling Variable Contribution of Price Cost Margin Boards $ 500 $ 300 $ 200 500 1,000 450 550 300 800
% of Total 62.5% (500 800) 37.5% (300 800) 100.0%
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Number Description of Boards Surfboards 500 Sailboards 300 Total sold 800

CVP Analysis with Multiple Products

Weighted-average unit contribution margin
Contribution Weighted Description Margin % of Total Contribution Surfboards $ 200 62.5% $ 125.00 Sailboards 550 37.5% 206.25 Weighted-average contribution margin $ 331.25

$200 62.5% $550 37.5%

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CVP Analysis with Multiple Products

Break-even point
Break-even Fixed expenses = point Weighted-average unit contribution margin

Break-even = point

$170,000 $331.25

Break-even = 514 combined unit sales point

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CVP Analysis with Multiple Products

Break-even point
Break-even point = 514 combined unit sales
% of Individual Total Sales 62.5% 321 37.5% 193 514

Description Surfboards Sailboards Total units

Breakeven Sales 514 514

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Assumptions Underlying CVP Analysis

1. Selling price is constant throughout the entire relevant range. 2. Costs are linear over the relevant range. 3. In multi-product companies, the sales mix is constant. 4. In manufacturing firms, inventories do not change (units produced = units sold).
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CVP Relationships and the Income Statement

A. Traditional Format ACCUTIME COMPANY Income Statement For the Year Ended December 31, 20x1 Sales Less: Gross margin Less: Operating expenses: Selling expenses Administrative expenses Net income $500,000 380,000 $120,000 $35,000 35,000

70,000 $50,000

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CVP Relationships and the Income Statement

B. Contribution Format ACCUTIME COMPANY Income Statement For the Year Ended December 31, 20x1 Sales Less: Variable expenses: Variable manufacturing Variable selling Variable administrative Contribution margin Less: Fixed expenses: Fixed manufacturing Fixed selling Fixed administrative Net income $500,000 $280,000 15,000 5,000

300,000 $200,000

$100,000 20,000 30,000

150,000 $50,000
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Cost Structure and Operating Leverage

The cost structure of an organization is the relative proportion of its fixed and variable costs. Operating leverage is . . .
the extent to which an organization uses fixed costs in its cost structure.

greatest in companies that have a high proportion of fixed costs in relation to variable costs.
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Measuring Operating Leverage

Operating leverage factor = Contribution margin Net income
Actual sales 500 Board $ 250,000 150,000 100,000 80,000 $ 20,000

Sales Less: variable expenses Contribution margin Less: fixed expenses Net income

$100,000 $20,000

= 5
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Measuring Operating Leverage

A measure of how a percentage change in sales will affect profits. If Curl increases its sales by 10%, what will be the percentage increase in net income?

Percent increase in sales Operating leverage factor Percent increase in profits

10% 5 50%
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Measuring Operating Leverage

A firm with proportionately high fixed costs has relatively high operating leverage On the other hand, a firm with high operating leverage has a relatively high break-even point.
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End of Chapter 7
We made it!

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