Lesson FA xx. Cost-Volume-Profit Analysis

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1 Lesson FA xx Cost-Volume-Profit Analysis This workbook contains notes and worksheets to accompany the corresponding video lesson available online at: Permission is granted for educators and students to make copies and redistribute this document without fee provided the copyright notice and page footer is retained. All other intellectual property rights are reserved by the copyright holder. Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 1 of 24

2 Cost-Volume-Profit Analysis Part 1 [Clip 01] Definitions of Fixed, Variable, and Mixed Costs Pre-requisites: Understand the fundamental concepts of accounting from a first accounting course, especially with regard to the income statement. Objectives: 1. Distinguish between fixed costs and variable costs 2. Use the high low method to separate fixed and variable components from a mixed cost. 3. Understand the concept of breakeven and determine breakeven point in both units and in revenue. 4. Understand the concept of target net income and determine the target net income point in both units and in revenue. 5. Understand the concept of margin of safety and determine the margin of safety of a given level of revenue. 6. Understand the cost-volume-profit graph in relation to sensitivity analysis. 7. Understand how to use cost-volume-profit analysis to answer what-if questions and interpret the results of changing assumptions. Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 2 of 24

3 Cost-Volume-Profit (CVP) Analysis Cost-Volume-Profit Analysis compares costs and revenue based on cost behavior. Costs behave in one of two primary ways fixed and variable, with a third hybrid behavior called variously mixed, semi-fixed, or semi-variable. Fixed Costs are costs that are fixed in total regardless of the level of activity at normal levels of activity. Suppose we have a bicycle assembly plant in which has a normal capacity to manufacture between 5,000 and 10,000 bicycles per month. Fixed costs associated with bicycle assembly would include fixed manufacturing overhead plus fixed period costs such as fixed administrative expenses. For example, property tax expense would not vary in total if we produced 5,000 bicycles versus 10,000 bicycles. It would likely be the same in total no matter how many bicycles we produced. Variable costs are costs that vary in total with the level of activity; and more specifically, vary in proportion to the level of activity at normal levels of activity. This is to say that there is a constant unit variable cost for each unit at normal levels of activity, but the total variable cost varies depending on the level of activity. Let s use our bicycle assembly plant as an example again. Variable costs associated with bicycles would include direct materials and direct labor as well as variable period costs such as selling expenses. For example, the cost of bicycle frames used in assembly would be the same for identical bicycles, but would vary in total depending on how many bicycles were produced and sold. If a bicycle frame costs $35 then total variable costs for bicycle frames depends on how many bicycles are produced and sold. Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 3 of 24

4 If we produced and sold 5,000 bicycles the total variable cost is $175,000. For 10,000 bicycles it would be $350,000. Mixed Costs are costs that include a fixed component and a variable component. In our bicycle assembly plant, a mixed cost might include: Certain indirect labor, indirect materials, repairs and maintenance, and other manufacturing overhead that is neither strictly fixed in total with respect to the level of activity or variable in total in proportion to the level of activity For example, suppose in our bicycle assembly plant some bicycle parts are manufactured with high-tech machinery rather than purchased. The cost of repairs and maintenance and lubrication of the machinery might behave as a mixed cost. In other words, there are some repair and maintenance and lubrication costs in total (fixed costs) that are necessary for any level of manufacture, and some amount of costs that will increase in proportion with increased utilization (variable costs). Mixed costs must be analyzed as to their fixed and variable components in order to apply Cost-Volume-Profit Analysis. Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 4 of 24

5 [Clip 02] Analyzing a Mixed Cost Using the High-Low Method - Part 1 Analyzing Mixed Costs Mixed costs can be analyzed using statistical methods such as regression or with simple mathematical models from algebra. For our purposes we will use a simple mathematical model from algebra you should already be familiar with. In order to analyze mixed costs, it is necessary to have a history of costs at different activity levels as a starting point. For example, suppose we have observed the following repair and maintenance costs for machinery in a capital intensive factory: Total monthly Machine hours Total monthly Repair and Maintenance cost May 80,000 hours $70,000 June 90,000 hours $75,000 July 110,000 hours $80,000 August 120,000 hours $100,000 September 100,000 hours $80,000 How can we use this information to estimate the total fixed costs and the variable cost per unit for repairs and maintenance? Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 5 of 24

6 [Clip 03] Analyzing a Mixed Cost Using the High-Low Method - Part 2 Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 6 of 24

7 [Clip 04] The CVP Income Statement as an Analytical Tool Cost-Volume-Profit (CVP) Income Statement Revenue Variable Costs Contribution Margin Total Unit Ratio Fixed Costs Net Income Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 7 of 24

8 [Clip 05] CVP Example - Determining Net Income Lanzas Company manufactures and sells LCD televisions. Lanzas Company sold 2,500 LCD televisions in the month of January. The selling price for the LCD televisions is $800. Costs include $500 per unit variable cost and $600,000 in total fixed costs. How much net income did Lanzas Company earn in January? Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 8 of 24

9 [Clip 06] CVP Example - Determining Breakeven Lanzas Company manufactures and sells LCD televisions. Lanzas Company sold 2,500 LCD televisions in the month of January. The selling price for the LCD televisions is $800. Costs include $500 per unit variable cost and $600,000 in total fixed costs. How many units must Lanzas sell to exactly cover total fixed costs and total variable costs? [Clip 07] CVP Example - Breakeven Formulas Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 9 of 24

10 [Clip 08] CVP Example - Target Net Income Formulas Lanzas Company manufactures and sells LCD televisions. Lanzas Company sold 2,500 LCD televisions in the month of January. The selling price for the LCD televisions is $800. Costs include $500 per unit variable cost and $600,000 in total fixed costs. How many units must Lanzas sell to earn a net income of $120,000. Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 10 of 24

11 [Clip 09] CVP Example - Margin of Safety Analysis Lanzas Company manufactures and sells LCD televisions. Lanzas Company sold 2,500 LCD televisions in the month of January. The selling price for the LCD televisions is $800. Costs include $500 per unit variable cost and $600,000 in total fixed costs. How much can actual January revenue decline before the breakeven point is reached? How much can Target Net Income revenue associated with net income of $120,000 decline before the breakeven point is reached? Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 11 of 24

12 [Clip 10] Summary of CVP Analysis Formulas Analytical Tools in Cost-Volume-Profit Analysis Breakeven Point (units) = Fixed Costs Contribution Margin Per Unit Breakeven Revenue = Alternatively: Fixed Costs Contribution Margin Ratio Breakeven Revenue = BEP units X Selling Price Per Unit Target Net Income Point (units) = Fixed Costs + Target Net Income Contribution Margin Per Unit Target Net Income Revenue = Alternatively: Fixed Costs + Target Net Income Contribution Margin Ratio Target Net Income Revenue = TNIP units X Selling Price Per Unit Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 12 of 24

13 Analytical Tools in Cost-Volume-Profit Analysis (continued) Margin of Safety (revenue difference) = Actual Revenue - Breakeven Revenue Margin of Safety (percentage) = Revenue Difference for Actual Revenue Actual Revenue Margin of Safety (revenue difference) = Target Net Income Revenue - Breakeven Revenue Margin of Safety (percentage) = Revenue Difference for Target Net Income Revenue Target Net Income Revenue Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 13 of 24

14 Cost-Volume-Profit Analysis Part 2 [Clip 11] Cost-Volume-Profit Graph - Part 1 - Total Revenue, Total Fixed Costs, and Total Costs Cost-Volume-Profit Graph A cost-volume-profit graph visually illustrates concepts of breakeven, profit, and losses for various activity levels. Let s revisit our example situation for Lanzas Company and illustrate it with a costvolume-profit graph. Lanzas Company manufactures and sells LCD televisions. Lanzas Company sold 2,500 LCD televisions in the month of January. The selling price for the LCD televisions is $800. Costs include $500 per unit variable cost and $600,000 in total fixed costs. Review: Actual sales of 2500 units in January was associated with: 1. revenue of $2,000,000 ($800 selling price) 2. total variable costs of $1,250,000 ($500 per unit) 3. fixed costs of $600, profit of $150,000 Breakeven sales of 2000 units is associated with: 1. breakeven revenue of $1,600,000 ($800 selling price) 2. variable costs of $500 per unit 3. total fixed costs of $600,000 Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 14 of 24

15 Blank Worksheet (see next page for completed graph). Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 15 of 24

16 [Clip 12] Cost-Volume-Profit Graph - Part 2 - Breakeven, Profits, Losses, and Margin of Safety (see completed graph in Clip 11) [Clip 13] Cost-Volume-Profit Graph - Part 3 - Sensitivity Analysis (see completed graph in Clip 11) Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 16 of 24

17 [Clip 14] Cost-Volume-Profit Graph - Part 4 - A Spreadsheet Solution Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 17 of 24

18 [Clip 15] CVP Analysis - Problem 1 - Increase Marketing Budget to Increase Sales Units Problem 1. Lanzas Company manufactures and sells LCD televisions. Lanzas Company sold 2,500 LCD televisions in the month of January. The selling price for the LCD televisions is $800. Costs include $500 per unit variable cost and $600,000 in total fixed costs. Management is considering a proposal from the marketing department to increase the marketing budget by $100,000 per month. The marketing department s best estimate is that increasing the marketing budget by this amount will increase unit sales 10% assuming all other factors remain the same. Instructions: Evaluate the proposal s effect on net income, margin of safety, and breakeven, using actual sales in January as your basis. Remember: Actual sales of 2500 units in January yielded $2,000,000 in actual revenue and $150,000 in actual net income. Also, breakeven quantity was 2000 units and breakeven revenue was $1,600,000. Problem 1. WORKSHEET. Instructions: Evaluate the proposal s effect on net income, margin of safety, and breakeven, using actual sales in January as your basis. CVP Income Statement Worksheet Total Unit Ratio Revenue Variable Costs Contribution Margin Fixed Costs Net Income BEFORE AFTER DIFFERENCE Net Income $150,000 Breakeven Point 2000 units Margin of Safety Ratio 20% (see Appendix 1 for the Solution) Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 18 of 24

19 [Clip 16] CVP Analysis - Problem 2 - Increase in Total Fixed Costs Results in Decrease in VC/unit Problem 2. Lanzas Company manufactures and sells LCD televisions. Lanzas Company sold 2,500 LCD televisions in the month of January. The selling price for the LCD televisions is $800. Costs include $500 per unit variable cost and $600,000 in total fixed costs. Management is considering an inventory management proposal which would increase fixed costs by $50,000 per month, but decrease variable costs to $400 per unit. Instructions: Evaluate the proposal s effect on net income, margin of safety, and breakeven, using actual sales in January as your basis. Remember: Actual sales of 2500 units in January yielded $2,000,000 in actual revenue and $150,000 in actual net income. Also, breakeven quantity was 2000 units and breakeven revenue was $1,600,000. Problem 2. WORKSHEET. Instructions: Evaluate the proposal s effect on net income, margin of safety, and breakeven, using actual sales in January as your basis. CVP Income Statement Worksheet Revenue Variable Costs Contribution Margin Total Unit Ratio Fixed Costs Net Income BEFORE AFTER DIFFERENCE Net Income $150,000 Breakeven Point 2000 units Margin of Safety Ratio 20% (see Appendix 1 for the Solution) Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 19 of 24

20 [Clip 17] CVP Analysis - Problem 3 - Decrease Selling Price to Increase Unit Sales Problem 3. Lanzas Company manufactures and sells LCD televisions. Lanzas Company sold 2,500 LCD televisions in the month of January. The selling price for the LCD televisions is $800. Costs include $500 per unit variable cost and $600,000 in total fixed costs. Prices for LCD televisions are very competitive. Management is considering a proposal to lower the selling price of LCD televisions by 10%. Unit sales are estimated to increase 15% if the selling price is dropped 10%. Instructions: Evaluate the proposal s effect on net income, margin of safety, and breakeven, using actual sales in January as your basis. Remember: Actual sales of 2500 units in January yielded $2,000,000 in actual revenue and $150,000 in actual net income. Also, breakeven quantity was 2000 units and breakeven revenue was $1,600,000. Problem 3. WORKSHEET. Instructions: Evaluate the proposal s effect on net income, margin of safety, and breakeven, using actual sales in January as your basis. CVP Income Statement Worksheet Revenue Variable Costs Contribution Margin Total Unit Ratio Fixed Costs Net Income BEFORE AFTER DIFFERENCE Net Income $150,000 Breakeven Point 2000 units Margin of Safety Ratio 20% (see Appendix 1 for the Solution) Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 20 of 24

21 APPENDIX 1 SOLUTIONS [Clip 15] CVP Analysis - Problem 1 - Increase Marketing Budget to Increase Sales Units SOLUTION: [Clip 16] CVP Analysis - Problem 2 - Increase in Total Fixed Costs Results in Decrease in VC/unit SOLUTION: Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 21 of 24

22 [Clip 17] CVP Analysis - Problem 3 - Decrease Selling Price to Increase Unit Sales SOLUTION: Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 22 of 24

23 APPENDIX 2 WORKSHEETS Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 23 of 24

24 Cost-Volume-Profit (CVP) Income Statement Revenue Variable Costs Contribution Margin Total Unit Ratio Fixed Costs Net Income Copyright 2011 by Rocky Spears Enterprises LLC, All Rights Reserved Page 24 of 24

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