Assumptions of CVP Analysis. Objective 1: Contribution Margin Income Statement. Assumptions of CVP Analysis. Contribution Margin Example

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1 Assumptions of CVP Analysis Cost-Volume-Profit Analysis Expenses can be classified as either variable or fixed. CVP relationships are linear over a wide range of production and sales. Sales prices, unit variable cost, and total fixed expenses will not vary within the relevant range. Assumptions of CVP Analysis Volume is the only cost driver. The relevant range of volume is specified. Inventory levels will be unchanged. The sales mix remains unchanged during the period. Objective 1: Contribution Margin Income Statement Sales -Variable Costs Contribution Margin -Fixed Costs Operating Profit Contribution Margin Example Ann and Tom manufacture a device that allows users to take a closer look at icebergs from a ship. The usual price for the device is $100. Variable costs are $70 per unit. They receive a proposal from a company in Newfoundland to sell 20,000 units at a price of $85. There is sufficient capacity to produce the order. Contribution Margin Example How do we analyze this situation? $85 $70 $15 contribution margin. $15 20,000 units $300,000 (total increase in contribution margin) 22-1

2 Contribution Margin Income Statement Sales (20,000 x $85) $1,700,000 Variable costs (20,000 x $70) (1,400,000) Contribution margin $300,000 Computing The unique sales level at which a company earns neither a profit nor incurs a loss. Or Sales Variable Costs Fixed Costs 0 Contribution required to break-even Breakeven Point Example Let s look back at Luis and Tom s manufacturing, assuming that the fixed cost are $90,000. Contribution margin Income statement: Sales (20,000 x $85) $1,700,000 Variable costs (20,000 x $70) (1,400,000) Contribution margin $300,000 Less $90,000 Profit $210,000 Objective 2 Use CVP analysis for profit planning and graph the cost-volume-profit relations Preparing a CVP Chart Plot total fixed costs on the vertical axis. Preparing a CVP Chart Starting at the origin, draw the sales line with a slope equal to the unit sales price. Sales Costs and Rev venue in Dollars Total fixed costs Total costs Draw the total cost line with a slope equal to the unit variable cost. Costs and Rev venue in Dollars Total fixed costs Breakeven Point Total costs Volume in Units Volume in Units 22-2

3 Various Sales Levels Example What operating profit is expected when sales are 22000units? Target Operating Profit Example Suppose that our business would be content with operating profit of $30 000_. How many units must be sold? Objective 4 Use CVP method to perform sensitivity analysis. Change in Sales Price Example Suppose that the sales price per device is _$60_ rather than $85_ What is the revised breakeven sales in units? Change in Variable Costs Example Suppose that variable expenses per device are _$75 instead of _$70 Other factors remain unchanged. Change in Fixed Costs Example Suppose that fixed costs increased by $30,000. What are the new fixed costs? What is the new breakeven point? 22-3

4 Margin of Safety Example Excess of expected sales over breakeven sales. E22-7 Atlanta Braves $7,000 $6,000 $5,000 $4,000 Break even in units 1,200, $3,000 Revenues Break $2,000 even in $ 1,200,000 x 24 $28,800,000 Total Expense $1,000 $ Fixed expense (in thousands) Break even point sands) (in thou Effect of sales mix on CVP analysis. Unit contribution margin is replaced with contribution margin for a composite unit. A composite unit is composed of specific numbers of each product in proportion to the product sales mix. Sales mix is the ratio of the volumes of the various products. The resulting break-even formula for composite unit sales is: A company sells windows and doors. They sell 4 windows for every door. Contribution margin Windows Doors Variable Cost Unit Contribution $ 75 $ 150 Sales Mix Ratio

5 Step 1: Compute contribution margin per composite unit. Windows Doors Variable Cost Unit Contribution $ 75 $ 150 Sales Mix Ratio Composite C/M Step 2: Compute break-even point in composite units. Contribution margin Step 2: Compute break-even point in composite units. Contribution ti margin $900,000 $450 per composite unit 2,000 composite units Step 3: Determine the number of windows and doors that must be sold to break even. Sales Composite Product Mix Units Units Window 4 2,000 8,000 Door 1 2,000 2,000 Multiproduct Break-Even Income Statement Step 4: Verify the results. Windows Doors Combined Variable Cost Unit Contribution $ $ Sales Volume 8,000 2,000 Total Contribution $ 600,000 $ 300,000 $ 900,000 Fixed Costs 900,000 Income $