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Chapter 7 Cost-VolumeProfit Analysis Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Break-Even Point The break-even point is the point in the volume of activity where the organization’s revenues and expenses are equal. Sales Sales Less: Less: variable variable expenses expenses Contribution Contribution margin margin Less: Less: fixed fixed expenses expenses Net Net income income $$250,000 250,000 150,000 150,000 100,000 100,000 100,000 100,000 $$ -- 7-2 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 7-3 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 Sales(500 (500surf surfboards) boards) Less: Less: variable variableexpenses expenses Contribution Contributionmargin margin Less: Less: fixed fixedexpenses expenses Net Net income income Total Total $$250,000 250,000 150,000 150,000 $$100,000 100,000 80,000 80,000 $$ 20,000 20,000 Per Per Unit Unit $$ 500 500 300 300 $$ 200 200 Percent Percent 100% 100% 60% 60% 40% 40% 7-4 Contribution-Margin Approach Fixed expenses Unit contribution margin Sales Sales(500 (500surf surfboards) boards) Less: variable expenses Less: variable expenses Contribution Contributionmargin margin Less: Less:fixed fixedexpenses expenses Net Netincome income Break-even point = (in units) Total Total $$250,000 250,000 150,000 150,000 $$100,000 100,000 80,000 80,000 $$ 20,000 20,000 Per PerUnit Unit $$ 500 500 300 300 $$ 200 200 Percent Percent 100% 100% 60% 60% 40% 40% $80,000 = 400 surf boards $200 7-5 Contribution-Margin Approach Here is the proof! Sales Sales(400 (400surf surfboards) boards) Less: Less: variable variableexpenses expenses Contribution Contributionmargin margin Less: Less: fixed fixedexpenses expenses Net Net income income 400 × $500 = $200,000 Total Total $$200,000 200,000 120,000 120,000 $$ 80,000 80,000 80,000 80,000 $$ -- Per Per Unit Unit $$ 500 500 300 300 $$ 200 200 Percent Percent 100% 100% 60% 60% 40% 40% 400 × $300 = $120,000 7-6 Contribution Margin Ratio Calculate the break-even point in sales dollars rather than units by using the contribution margin ratio. Contribution margin = CM Ratio Sales Fixed expense Break-even point = CM Ratio (in sales dollars) 7-7 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.: 7-8 Cost-Volume-Profit Graph 450,000 400,000 350,000 Dollars 300,000 250,000 200,000 150,000 es s n x pe e l Tota Fixed expenses 100,000 50,000 100 200 300 400 Units 500 600 700 800 7-9 Cost-Volume-Profit Graph 450,000 400,000 350,000 Dollars 300,000 250,000 200,000 150,000 es s n x pe e l Tota Fixed expenses 100,000 50,000 100 200 300 400 Units 500 600 700 800 7-10 Cost-Volume-Profit Graph 450,000 400,000 es l a ls a t To 350,000 Dollars 300,000 250,000 200,000 150,000 es s n x pe e l Tota Fixed expenses 100,000 50,000 100 200 300 400 Units 500 600 700 800 7-11 Cost-Volume-Profit Graph 450,000 400,000 es l a ls ea a r t a o T fit o r P 350,000 Dollars 300,000 Break-even point 250,000 200,000 150,000 es s n x pe e l Tota 100,000 50,000 s Lo re a s 100 Fixed expenses a 200 300 400 Units 500 600 700 800 7-12 Profit-Volume Graph Some Some managers managers like like the the profit-volume profit-volume graph graph because because itit focuses focuses on on profits profits and and volume. volume. 100,000 80,000 60,000 Break-even point Profit 40,000 fit o r P 20,000 0 (20,000) (40,000) (60,000) a e r a ` 100 200 a e r a s s o L 300 400 Units 500 600 700 7-13 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 $80,000 + $100,000 $200 = Units sold to earn the target profit = 900 surf boards 7-14 Equation Approach Sales revenue – Variable expenses – Fixed expenses = Profit ($500 × X) – ($300 × X) – $80,000 = $100,000 ($200X) = $180,000 X = 900 surf boards 7-15 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 occur. 7-16 CVP Analysis with Multiple Products For a company with more than one product, sales mix is the relative combination in which a company’s products are sold. Different products have different selling prices, cost structures, and contribution margins. Let’s assume Curl sells surfboards and sail boards and see how we deal with break-even analysis. 7-17 CVP Analysis with Multiple Products Curl provides us with the following: information: 7-18 CVP Analysis with Multiple Products Weighted-average unit contribution margin $200 × 62.5% $550 × 37.5% 7-19 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 7-20 CVP Analysis with Multiple Products Break-even point Break-even point = 514 combined unit sales 7-21 Assumptions Underlying CVP Analysis 1. Selling price is constant 2. 3. 4. throughout the entire relevant range. Costs are linear over the relevant range. In multi-product companies, the sales mix is constant. In manufacturing firms, inventories do not change (units produced = units sold). 7-22 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 7-23 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 $100,000 20,000 30,000 300,000 $200,000 150,000 $50,000 7-24 Cost Structure and Operating Leverage  The The cost cost structure structure of of an an organization organization is is the the relative relative proportion proportion of of its its fixed fixed and and variable variable costs. costs.  Operating Operating leverage leverage is: is:  the the extent extent to to which which an an organization organization uses uses fixed fixed costs costs in in its its cost cost structure. structure.  greatest greatest in in companies companies that that have have aa high high proportion proportion of of fixed fixed costs costs in in relation relation to to variable variable costs. costs. 7-25 Measuring Operating Leverage Operating leverage factor = Contribution margin Net income $100,000 = 5 $20,000 7-26 Measuring Operating Leverage A A measure measure of of how how aa percentage percentage change change in in sales sales will will affect affect profits. profits. If If Curl Curl increases increases its its sales sales by by 10%, 10%, what what will will be be the the percentage percentage increase increase in in net net income? income? Percent increase in sales Operating leverage factor × Percent increase in profits 10% 5 50% 7-27 CVP Analysis, Activity-Based Costing, and Advanced Manufacturing Systems An activity-based costing system provides a much more complete picture of cost-volume-profit relationships and, thus, it provides better information to managers. Break-even = Fixed costs point Unit contribution margin 7-28 A Move Toward JIT and Flexible Manufacturing Overhead costs like setup, inspection, and material handling are fixed with respect to sales volume, but they are not fixed with respect to other cost drivers. This is the fundamental distinction between a traditional CVP analysis and an activitybased costing CVP analysis. 7-29 Effect of Income Taxes Income taxes affect a company’s CVP relationships. To earn a particular after-tax net income, a greater before-tax income will be required. Target after-tax net income Before-tax = net income 1 - t 7-30