Week 7 – Chapter 8 COST-VOLUME-PROFIT

ANALYSIS

FNSACC507A Provide Management Accounting Information

In this lesson you will learn how to…

Provide an analysis of COST-VOLUME-PROFIT

relationships.

By the end of this lesson, you need to know how to…

Calculate: a. break-even sales in $ and units b. sales in $ and units required to earn a target profit c. the margin of safety and margin of safety ratio

Overview 1.  Basic profit equation 2.  Break-even analysis 3.  The contribution concept 4.  Applying cost-volume-profit (CVP) analysis

1.  Required selling price ($) 2.  Break-even sales (units) 3.  Break-even sales ($) 4.  Target profit calculations 5.  Margin of safety

5.  CVP analysis à assumptions

1. Basic profit equation The basic equation relating before tax profits to revenues and costs is:

PROFIT = TR - TC

Where; TR = Total revenue for the period TC = Total cost (i.e. fixed costs + variable costs) for the

period Profit = Net operating profit before tax

2. Break-even analysis (BEA) What is it? Break-even analysis (BEA) is used to work out the sales volume or activity level for which the profit generated is zero beyond which, any increase in production resulting in increased sales will lead to a positive profit.

Break-even chart $"

Break-even point (BEP) (interpreting the graph on the previous slide) The break-even point: � is where the TR line and the TC line intersect � corresponds to the production volume at which total revenues = total costs. � represents the point at which the firm makes neither a profit nor a loss.

BEP à TR – TC = 0

3. The contribution concept

The CONTRIBUTION MARGIN (CM) represents the amount in $ available to cover FIXED COSTS and contribute towards the earning of PROFIT.

Per unit value

@ 1,000 units @ 2,000 units @ 4,000 units

Selling price $15 $15,000 $30,000 $60,000

Less: Variable cost $8 $8,000 $16,000 $32,000

Contribution margin

$7 $7,000 $14,000 $28,000

Less: Total fixed costs

$6,000 $6,000 $6,000

Net profit $1,000 $8,000 $22,000

�  The CONTRIBUTION MARGIN RATIO (CMR) represents the ratio of the contribution margin to sales.

�  CMR = CM per unit ($7) / Selling Price per unit ($15) �  In the example above, 47% of every sales

dollar is available to cover FIXED COSTS and contribute towards the earning of PROFIT.

Per unit value

RATIO

Selling price $15 100% Less: Variable cost $8 53% VCR

(variable cost ratio) Contribution margin $7 47% CMR

(contribution margin ratio)

Contribution margin analysis Contribution margin analysis

focuses on a firm’s

operating leverage * * * * * * *

In other words it measures how

growth in sales translates into

growth in profits

Contribution margin analysis OPERATING LEVERAGE

* * * * * * *

Refers to the % of fixed costs in an organisation’s total cost structure.

* * * * * * * The higher this fixed cost %, the more the organisation’s profits will be affected by

fluctuations in sales volume.

4. Applying CVP analysis � Given the contribution margin, you can easily

work out break-even and target sales (in units).

� Management can then use this information to make more informed decisions about things like: �  whether to add or subtract a product line �  how to price a product or service �  how to structure sales commissions or bonuses etc.

4a. Required selling price ($) 4b. Break-even sales (UNITS) 4c. Break-even sales ($) 4d. Target profit ($)

Wait…   Before moving on to the next slide, please open and work through the following documents now: 1. A summary of the all the different types of formulae which you need to know how to use for CVP analysis – OPEN: WEEK 7_FNSACC507A_Management Accounting_LESSON 7_Learning Material 1_Formulae Summary 2. A step-by-step example illustrating the use of each formula – OPEN: WEEK 7_FNSACC507A_Management Accounting_LESSON 7_Learning Material 2_Formulae Example 3. Graphs to accompany the step-by-step example – OPEN: WEEK 7_FNSACC507A_Management Accounting_LESSON 7_Learning Material 3_Graphs for Example

4e. Margin of safety � The margin of safety is the excess of projected or

actual sales units over the break-even sales units.

Margin of safety"="

Projected or actual sales (units)"-"

Break-even sales (units)"

4e. Margin of safety (example)

If the actual level of sales activity is 1,000 units and the break-even level of sales activity is 750 units, then the margin of safety is 250 units.

Margin of safety"="

Projected or actual sales (units)"-"

Break-even sales (units)"

4e. Margin of safety RATIO

In our previous example, this means that the firm’s sales volume can drop by 25% (i.e. 250 / 1,000) before the firm incurs a loss, other things held constant.

Margin of safety RATIO (%)"="

Margin of safety (units) / Projected or actual sales (units)"

CVP Analysis 5. Assumptions

� Total cost can be separated into its fixed & variable components.

� Fixed costs remain constant with changes in volume.

� Variable costs are in direct proportion to volume.

� All production is sold.

•  There are no significant changes in inventory levels.

•  Production and management policies are held constant during the period.

•  A constant contribution margin applies, or if there is more than one product, a constant average contribution margin applies.

Worked Example

Cost-Volume-Profit Analysis Rory Ltd

Worked Examples  NOTE TO STUDENTS:

Before moving on to the next slide, please open and work through the following document now:

WEEK 7_FNSACC507A_Management

Accounting_WORKED EXAMPLES

This week’s homework � Read chapter 8 à Cost-volume-profit analysis

(p.390 to p.415) � Complete homework questions (chapter 8)

(ref. STUDENT ONLINE STUDY GUIDE)

This  is  the  end  of  the  last  lesson.  Thank  you  for  par6cipa6ng    in  this  online  unit  of  study.