CHAPTER 3: ANALYSIS OF COST VOLUME AND PRICING TO INCREASE PROFITABILITY - CVP ANALYSIS Pearson Education. All rights reserved.

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1 CHAPTER 3: ANALYSIS OF COST VOLUME AND PRICING TO INCREASE PROFITABILITY - CVP ANALYSIS

2 Learning Objectives 1. Explain the features of cost-volume-profit (CVP) analysis 2. Determine the breakeven point and output level needed to achieve a target operating income 3. Explain how managers use CVP analysis in decision making 4. Explain how sensitivity analysis helps managers cope with uncertainty

3 Learning Objectives 6. Use CVP analysis to plan variable and fixed costs 7. Apply CVP analysis in service and not-for-profit organizations 8. Distinguish contribution margin from gross margin

4 Explain the Features of Cost- Volume-Profit (CVP) Analysis Learning Objective 1

5 Cost-Volume-Profit Analysis Analysis of the behavior and relationship among total revenues, total costs, and income as the units sold, selling price, variable cost per unit, or fixed costs change

6 Steps in Decision Making Identify the problem and uncertainties Obtain information Make predictions about the future Make decisions by choosing among alternatives Implement the decision, evaluate performance, and learn

7 Contribution Margin Difference between total revenues and total variable costs

8 Exhibit Contribution Income Statement

9 Contribution Margin Percentage Calculating contribution margin per unit is cumbersome when companies have multiple products It is contribution margin as a percentage, instead of dollars It is the contribution margin per dollar of revenue

10 Expressing CVP Relationships Three related ways in which cost-volume-profit relationships can be analyzed: Equation method Contribution method Graph method

11 Equation Method Based on the operating income equation: Operating income = Revenues Variable costs Fixed costs This equation can be further expanded as: Operating income = [(Selling price Quantity of units sold) (Variable per unit Quantity of units sold)] Fixed costs

12 Contribution Margin Method Uses the contribution margin per unit to calculate the operating income Operating income = [(Contribution margin per unit) (Quantity of units sold)] Fixed costs

13 Exhibit Graph Method

14 Cost-Volume-Profit Assumptions The number of units sold is the only revenue driver and the only cost driver Total costs can be separated into two components: a fixed component and a variable component When represented graphically, the behaviors of total revenues and total costs are linear Selling price, variable cost per unit, and total fixed costs are known

15 Determine the Breakeven Point and Output Level Needed to Achieve a Target Operating Income Learning Objective 2

16 Breakeven Point Quantity of output sold at which total revenues equal total costs When there are multiple products, it is convenient to calculate breakeven point directly in terms of revenue

17 Target Operating Income Helps in determining the number of units that should be sold to achieve a target operating income

18 Exhibit Profit-Volume Graph Shows how changes in the quantity of units sold affect operating income

19 Target Net Income and Income Taxes Helps managers asses the effects of their decisions on operating income after taxes

20 Explain How Managers Use CVP Analysis in Decision Making Learning Objective 4

21 Using CVP Analysis for Decision Making Managers use CVP analysis to guide other decisions Decision to advertise Decision to reduce selling price Determining target prices It helps managers make product decisions by estimating the expected profitability of these decisions

22 Explain How Sensitivity Analysis Helps Managers Cope with Uncertainty Learning Objective 5

23 Sensitivity Analysis What-if technique used to recognize uncertainty by examining how an outcome will change if the original predicted data or assumption change Broadens managers perspectives to possible outcomes that might occur before the company commits to funding the project Electronic spreadsheets enable managers to systematically and efficiently conduct analyses

24 Margin of Safety

25 Use CVP Analysis to Plan Variable and Fixed Costs Learning Objective 6

26 Alternative Fixed-Cost/Variable-Cost Structures Managers have the ability to choose the levels of fixed and variable costs in their cost structures Sensitivity analysis helps examine the risks and returns in a company cost structure As fixed costs are substituted for variable costs

27 Operating Leverage Describes the effects that fixed costs have on changes in operating income as changes occur in units sold and contribution margin. Organizations with high proportion of fixed costs will have higher operating leverage

28 Apply CVP Analysis to a Company Producing Multiple Products Learning Objective 7

29 Effects of Sales Mix on CVP Formulae presented to this point have assumed a single product is produced and sold Most companies sell a large variety of products Sales mix is the quantities or proportions of various products or services that constitute total unit sales of a company

30 Effects of Sales Mix on CVP Total number of units that must be sold to break even in a multiproduct company depends on the sales mix CVP analysis with multiple products is performed by calculating a weighted average contribution margin based upon a constant sales mix percentage

31 Calculation of Break-even-point With Multiple Products Assume that the budgeted sales mix will not change at different levels of total unit sales

32 Effects of Sales Mix on Income Many different sales mixes can result a given contribution margin Choice of sales mix affects the operating income of a company Companies adjust their sales mix to respond to demand changes

33 Apply CVP Analysis in Service and Not-for-Profit Organizations Learning Objective 8

34 CVP Analysis in Service and Not-for- Profit Organizations To apply CVP analysis, the focus must be on measuring organizational output Measuring output is different from the tangible units sold by manufacturing and merchandising companies

35 Distinguish Contribution Margin from Gross Margin Learning Objective 9

36 Contribution Margin v/s Gross Margin Contribution Margin Contribution margin indicates how much of a company s revenues are available to cover fixed costs Gross Margin Gross margin measures how much a company can charge for its products over and above the cost of acquiring or producing them