1. Chapter 7 Cost-Volume- Profit Analysis Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

2. Learning Objective 1 Compute a break- even point using the contribution-margin approach and the equation approach 7-2 3. 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 -$ 7-3 4. Equation Approach Sales revenue Variable expenses Fixed expenses = Profit Unit sales price Sales volume in units Unit variable expense Sales volume in units ($500 X) ($300 X) $80,000 = $0 ($200X) $80,000 = $0 X = 400 surf boards 7-4 5. Cost-Volume-Profit Analysis Break-Even Point Number of units sold that allow the company to neither earn a profit nor incur a loss $0 = SP(x) VC(x) Fixed Costs CodeConnect has the following cost structure Selling price $200.00 per unit Variable cost $90.83 per unit Total fixed cost $160,285 Find CodeConnects break-even point (in units) Slide 7-5 6. Cost-Volume-Profit Analysis Break-Even Point $0 = SP(x) VC(x) TFC $0 = [$200.00 (x)] [$90.83(x)] $160,285 $0 = [($200.00 $90.83)(x)] $160,285 $0 = $109.17(x) $160,285 $109.17(x) = $160,285 x = $160,285 / $109.17 (Fixed Costs/CM per unit) x = 1,468.21 units Break-even point is 1,469 units (always round up) Slide 7-6 7. Contribution-Margin Approach For each additional surf board sold, Curl generates $200 in contribution margin. Total Per Unit Percent Sales (500 surf boards) 250,000$ 500$ 100% Less: variable expenses 150,000 300 60% Contribution margin 100,000$ 200$ 40% Less: fixed expenses 80,000 Net income 20,000$ Consider the following information developed by the accountant at Curl, Inc.: 7-7 8. Contribution-Margin Approach Fixed expenses Unit contribution margin = Break-even point (in units) Total Per Unit Percent Sales (500 surf boards) 250,000$ 500$ 100% Less: variable expenses 150,000 300 60% Contribution margin 100,000$ 200$ 40% Less: fixed expenses 80,000 Net income 20,000$ $80,000 $200 = 400 surf boards 7-8 9. Contribution-Margin Approach Here is the proof! Total Per Unit Percent Sales (400 surf boards) 200,000$ 500$ 100% Less: variable expenses 120,000 300 60% Contribution margin 80,000$ 200$ 40% Less: fixed expenses 80,000 Net income -$ 400 $500 = $200,000 400 $300 = $120,000 7-9 10. Learning Objective 2 Compute the contribution- margin ratio and use it to find the break-even point in sales dollars 7-10 11. Contribution Margin Ratio Calculate the break-even point in sales dollars rather than units by using the contribution margin ratio. Contribution margin Sales = CM Ratio Fixed expense CM Ratio Break-even point (in sales dollars) = 7-11 12. Total Per Unit Percent Sales (400 surf boards) 200,000$ 500$ 100% Less: variable expenses 120,000 300 60% Contribution margin 80,000$ 200$ 40% Less: fixed expenses 80,000 Net income -$ Contribution Margin Ratio $80,000 40% $200,000 sales= 7-12 13. Learning Objective 3 Prepare a cost- volume-profit (CVP) graph and explain how it is used 7-13 14. Graphing Cost-Volume-Profit Relationships Viewing CVP relationships in a graph gives managers a perspective that can be obtained in no other way. Consider the following information for Curl, Inc.: 300 units 400 units 500 units Sales 150,000$ 200,000$ 250,000$ Less: variable expenses 90,000 120,000 150,000 Contribution margin 60,000$ 80,000$ 100,000$ Less: fixed expenses 80,000 80,000 80,000 Net income (loss) (20,000)$ -$ 20,000$ 7-14 15. Cost-Volume-Profit Graph Dollars 600 700 800 Units 200 300 400 500 450,000 100 200,000 150,000 100,000 50,000 400,000 350,000 300,000 250,000 Fixed expenses 7-15 16. Cost-Volume-Profit Graph Dollars 600 700 800 Units 200 300 400 500 450,000 100 200,000 150,000 100,000 50,000 400,000 350,000 300,000 250,000 Fixed expenses 7-16 17. Cost-Volume-Profit Graph Dollars 600 700 800 Units 200 300 400 500 450,000 100 200,000 150,000 100,000 50,000 400,000 350,000 300,000 250,000 Fixed expenses 7-17 18. Cost-Volume-Profit Graph Dollars 600 700 800 Units 200 300 400 500 450,000 100 200,000 150,000 100,000 50,000 400,000 350,000 300,000 250,000 Fixed expenses 7-18 19. Cost-Volume-Profit Graph Dollars 600 700 800 Units 200 300 400 500 450,000 100 200,000 150,000 100,000 50,000 400,000 350,000 300,000 250,000 Fixed expenses Break-even point 7-19 20. Profit-Volume Graph Some managers like the profit-volume graph because it focuses on profits and volume. ` 100 200 300 400 500 600 700 Units Profit 0 100,000 (20,000) (40,000) (60,000) 80,000 60,000 40,000 20,000 Break-even point 7-20 21. Learning Objective 4 Apply CVP analysis to determine the effect on profit from changes in fixed expenses, variable expenses, sales prices, and sales volume 7-21 22. Radford University - M. Chatham - Managerial Accounting 22 Contribution Margin Method The contribution margin method is a variation of the equation method. Break-even point in units sold = Fixed expenses Contribution Margin per Unit Break-even point in total sales dollars = Fixed expenses Contribution Margin Ratio But is any entrepreneur interested in just breaking even? + Target Income + Target Income Before-tax net profits 23. 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 7-23 24. Equation Approach Sales revenue Variable expenses Fixed expenses = Profit ($500 X) ($300 X) $80,000 = $100,000 ($200X) = $180,000 X = 900 surf boards 7-24 25. Applying CVP Analysis Safety Margin (or Margin of Safety) The difference between budgeted sales revenue and break-even sales revenue. The amount by which sales can drop before losses begin to be incurred. 7-25 26. Safety Margin Curl, Inc. has a break-even point of $200,000. If actual sales are $250,000, the safety margin is $50,000 or 100 surf boards. Break-even sales 400 units Actual sales 500 units Sales 200,000$ 250,000$ Less: variable expenses 120,000 150,000 Contribution margin 80,000 100,000 Less: fixed expenses 80,000 80,000 Net income -$ 20,000$ 7-26 27. i>clicker question All other things (e.g., sales) remaining constant, what will happen to the margin of safety if fixed costs decrease? a) it will grow larger b) it will get smaller c) it will remain unchanged d) it dependsthere is not enough information to answer the question 28. Changes in Fixed Costs Curl is currently selling 500 surfboards per year. The owner believes that an increase of $10,000 in the annual advertising budget, would increase sales to 540 units. Should the company increase the advertising budget? 7-28 29. Current Sales (500 Boards) Proposed Sales (540 Boards) Sales 250,000$ 270,000$ Less: variable expenses 150,000 162,000 Contribution margin 100,000$ 108,000$ Less: fixed expenses 80,000 90,000 Net income 20,000$ 18,000$ Changes in Fixed Costs $80,000 + $10,000 advertising = $90,000 540 units $500 per unit = $270,000 7-29 30. Current Sales (500 Boards) Proposed Sales (540 Boards) Sales 250,000$ 270,000$ Less: variable expenses 150,000 162,000 Contribution margin 100,000$ 108,000$ Less: fixed expenses 80,000 90,000 Net income 20,000$ 18,000$ Changes in Fixed Costs Sales will increase by $20,000, but net income decreased by $2,000. 7-30 31. 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) 7-31 32. 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 7-32 33. Predicting Profit Given Expected Volume Fixed expenses Unit contribution margin Target net profit Find: {reqd sales volume}Given: Fixed expenses Unit contribution margin Expected sales volume Find: {expected profit}Given: 7-33 34. Predicting Profit Given Expected Volume In the coming year, Curls owner expects to sell 525 surfboards. The unit contribution margin is expected to be $190, and fixed costs are expected to increase to $90,000. ($190 525) $90,000 = X X = $9,750 profit X = $99,750 $90,000 Total contribution - Fixed cost = Profit 7-34 35. Learning Objective 5 Compute the break-even point and prepare a profit-volume graph for a multiproduct enterprise 7-35 36. CVP Analysis with Multiple Products For a company with more than one product, sales mix is the relative combination in which a companys products are sold. Different products have different selling prices, cost structures, and contribution margins. Lets assume Curl sells surfboards and sail boards and see how we deal with break- even analysis. 7-36 37. CVP Analysis with Multiple Products Curl provides us with the following information: Description Selling Price Unit Variable Cost Unit Contribution Margin Number of Boards Surfboards 500$ 300$ 200$ 500 Sailboards 1,000 450 550 300 Total sold 800 Description Number of Boards % of Total Surfboards 500 62.5% (500 800) Sailboards 300 37.5% (300 800) Total sold 800 100.0% 7-37 38. CVP Analysis with Multiple Products Weighted-average unit contribution margin Description Contribution Margin % of Total Weighted 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% 7-38 Description Number of Boards % of Total Surfboards 500 62.5% (500 800) Sailboards 300 37.5% (300 800) Total sold 800 100.0% 39. CVP Analysis with Multiple Products Break-even point Break-even point = Fixed expenses Weighted-average unit contribution margin Break-even point = $170,000 $331.25 Break-even point = 514 combined unit sales 7-39 40. CVP Analysis with Multiple Products Break-even point Break-even point = 514 combined unit sales Description Breakeven Sales % of Total Individual Sales Surfboards 514 62.5% 321 Sailboards 514 37.5% 193 Total units 514 7-40 41. Multiproduct Analysis Rohr Watch Company Model A Model B Total Selling price $2,000 $3,000 Variable cost 800 1,200 Contribution margin $1,200 $1,800 Units produced and sold 4,000 2,000 6,000 Weight 4,000 / 6,000 2,000 / 6,000 Weighted average contribution margin is [(2 $1,200) + (1 $1,800)]/3 = $1,400 per unit Break-even is $3,500,000 / $1,400 = 2,500 units Break-even is 2,500 (4,000 / 6,000) = 1,667 Model A units (Whole units.) Break-even is 2,500 (2,000 / 6,000) = 834 Model B units (Whole units.) Slide 7-41 42. i>clicker question If, everything else being equal (including sales), the sales mix changes so that relatively less of a product with a lesser contribution margin is sold? a) net profits will increase b) net profits will decrease c) sales will increase and net profits will remain unchanged d) sales will decrease and net profits will remain unchanged e) not enough information provided! 43. Learning Objective 6 List and discuss the key assumptions of CVP analysis 7-43 44. 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). 7-44 45. Learning Objective 7 Prepare and interpret a contribution income statement 7-45 46. CVP Relationships and the Income Statement A. Traditional Format Sales $500,000 Less: COGS 380,000 Gross margin $120,000 Less: Operating expenses: Selling expenses $35,000 Administrative expenses 35,000 70,000 Net income $50,000 ACCUTIME COMPANY Income Statement For the Year Ended December 31, 20x1 7-46 47. CVP Relationships and the Income Statement B. Contribution Format Sales $500,000 Less: Variable expenses: Variable manufacturing $280,000 Variable selling 15,000 Variable administrative 5,000 300,000 Contribution margin $200,000 Less: Fixed expenses: Fixed manufacturing $100,000 Fixed selling 20,000 Fixed administrative 30,000 150,000 Net income $50,000 Income Statement For the Year Ended December 31, 20x1 ACCUTIME COMPANY 7-47 48. Learning Objective 8 Explain the role of cost structure and operating leverage in CVP relationships 7-48 49. Cost Structure and Operating Leverage The cost structure of an organization is the relative proportion of its fixed and variable costs. Operating leverage is . . . the extent to which an organization uses fixed costs in its cost structure. greatest in companies that have a high proportion of fixed costs in relation to variable costs. 7-49 50. Measuring Operating Leverage Contribution margin Net income Operating leverage factor = Actual sales 500 Board Sales 250,000$ Less: variable expenses 150,000 Contribution margin 100,000 Less: fixed expenses 80,000 Net income 20,000$ $100,000 $20,000 = 5 7-50 51. Measuring Operating Leverage A measure of how a percentage change in sales will affect profits. If Curl increases its sales by 10%, what will be the percentage increase in net income? Percent increase in sales 10% Operating leverage factor 5 Percent increase in profits 50% 7-51 52. Measuring Operating Leverage A firm with proportionately high fixed costs has relatively high operating leverage. On the other hand, a firm with high operating leverage has a relatively high break-even point. 7-52 53. Radford University - M. Chatham - Managerial Accounting 53 CVP in Choosing a Cost Structure Cost structure refers to the relative proportion of fixed and variable costs in an organization. Bogside Farm and Sterling Farm are both in the blueberry business. Bogside depends on migrant workers to pick its berries, while Sterling uses expensive picking machinery. Bogside has higher variable costs, while Sterling has higher fixed costs. Lets look at the impact of cost structures on the two companies. 54. Radford University - M. Chatham - Managerial Accounting 54 CVP in Choosing a Cost Structure Amount % Amount % Sales 100,000$ 100% 100,000$ 100% Less: Variable expenses 60,000 60% 30,000 30% Contribution margin 40,000 40% 70,000 70% Less: Fixed costs 30,000 60,000 Net operating income 10,000$ 10,000$ Bogside Farm Sterling Farm Presented above is the current periods financial information for the two companies. Lets see what happens to income if each company experiences a 10% increase in sales revenue. 55. Radford University - M. Chatham - Managerial Accounting 55 CVP in Choosing a Cost Structure Amount % Amount % Sales 110,000$ 100% 110,000$ 100% Less: Variable expenses 66,000 60% 33,000 30% Contribution margin 44,000 40% 77,000 70% Less: Fixed costs 30,000 60,000 Net operating income 14,000$ 17,000$ Bogside Farm Sterling Farm Sterlings higher contribution margin leads to a larger increase in net operating income. Lets look at the breakeven sales dollars for each company. 56. Radford University - M. Chatham - Managerial Accounting 56 CVP in Choosing a Cost Structure Bogside has lower fixed expenses and is more protected from a downturn in sales. Bogside Sterling Amount Amount Fixed expenses 30,000$ 60,000$ Divided by: CM Ratio 40% 70% Breakeven sales 75,000$ 85,714$ 57. Radford University - M. Chatham - Managerial Accounting 57 Operating Leverage Operating leverage is a measure of how sensitive net operating income is to percentage changes in sales. (Degree of) Operating Leverage = Contribution Margin Net Operating Income 58. Learning Objective 9 Understand the implications of activity-based costing for CVP analysis 7-58 59. CVP Analysis, Activity-Based Costing, and Advanced Manufacturing Systems An activity-based costing system can provide a much more complete picture of cost- volume-profit relationships and thus provide better information to managers. Break-even point = Fixed costs Unit contribution margin 7-59 60. Learning Objective 10 Be aware of the effects of advanced manufacturing technology on CVP analysis 7-60 61. 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 activity- based costing CVP analysis. A Move Toward JIT and Flexible Manufacturing 7-61 62. Learning Objective 11 Understand the effect of income taxes on CVP analysis (appendix). 7-62 63. Radford University - M. Chatham - Managerial Accounting Contribution Margin Method The contribution margin method is a variation of the equation method. Break-even point in units sold = Fixed expenses Contribution Margin per Unit Break-even point in total sales dollars = Fixed expenses Contribution Margin Ratio But is any entrepreneur interested in just breaking even? + Target Income + Target Income Before-tax net profits 64. Effect of Income Taxes Target after-tax net income 1 - t = Before-tax net income Income taxes affect a companys CVP relationships. To earn a particular after-tax net income, a greater before-tax income will be required. 7-64 65. Slide 4-65 66. End of Chapter 7 We made it! 7-66 Congrats!!! And good luck with the homework!