Cost-Volume-Profit Analysis Chapter 3 2003 Prentice Hall Business

Cost-Volume-Profit Analysis Chapter 3 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-1

Learning Objective 1 Understand the assumptions underlying cost-volume-profit (CVP) analysis. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-2

Cost-Volume-Profit Assumptions and Terminology 1. Changes in the level of revenues and costs arise only because of changes in the number of product (or service) units produced and sold. 2. Total costs can be divided into a fixed component and a component that is variable with respect to the level of output. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-3

Cost-Volume-Profit Assumptions and Terminology 3. When graphed, the behavior of total revenues and total costs is linear (straight-line) in relation to output units within the relevant range (and time period). 4. The unit selling price, unit variable costs, and fixed costs are known and constant. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-4

Cost-Volume-Profit Assumptions and Terminology 5. The analysis either covers a single product or assumes that the sales mix when multiple products are sold will remain constant as the level of total units sold changes. 6. All revenues and costs can be added and compared without taking into account the time value of money. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-5

Cost-Volume-Profit Assumptions and Terminology Operating income Total revenues from operations – Cost of goods sold and operating costs (excluding income taxes) Net income Operating income – Income taxes 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-6

Learning Objective 2 Explain the features of CVP analysis. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-7

Essentials of Cost-Volume-Profit (CVP) Analysis Example Assume that the Pants Shop can purchase pants for 32 from a local factory; other variable costs amount to 10 per unit. The local factory allows the Pants Shop to return all unsold pants and receive a full 32 refund per pair of pants within one year. The average selling price per pair of pants is 70 and total fixed costs amount to 84,000. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-8

Essentials of Cost-Volume-Profit (CVP) Analysis Example How much revenue will the business receive if 2,500 units are sold? 2,500 70 175,000 How much variable costs will the business incur? 2,500 42 105,000 175,000 – 105,000 – 84,000 ( 14,000) 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-9

Essentials of Cost-Volume-Profit (CVP) Analysis Example What is the contribution margin per unit? 70 – 42 28 contribution margin per unit What is the total contribution margin when 2,500 pairs of pants are sold? 2,500 28 70,000 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 10

Essentials of Cost-Volume-Profit (CVP) Analysis Example Contribution margin percentage (contribution margin ratio) is the contribution margin per unit divided by the selling price. What is the contribution margin percentage? 28 70 40% 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 11

Essentials of Cost-Volume-Profit (CVP) Analysis Example If the business sells 3,000 pairs of pants, revenues will be 210,000 and contribution margin would equal 40% 210,000 84,000. FEDER AL RE SE RVE N O TE THE ITED STATES THE UN U NITED STAT ES OF O F AAMERICA MERIC A T H IS N O TE IS LE G A L T E N DE R F O R A L L D E B T S , P UB LI C AN D P RIV A T E L70744 629F 12 WA S HIN GT ON , D.C. 12 A H 293 L70744629F 12 S E RI ES 12 19 85 ON R ONEE D DOLLA O LLAR 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 12

Learning Objective 3 Determine the breakeven point and output level needed to achieve a target operating income using the equation, contribution margin, and graph methods. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 13

Breakeven Point Sales – Variable expenses Fixed expenses Total revenues Total costs 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 14

Abbreviations SP Selling price VCU Variable cost per unit CMU Contribution margin per unit CM% Contribution margin percentage FC Fixed costs 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 15

Abbreviations Q Quantity of output units sold (and manufactured) OI Operating income TOI Target operating income TNI Target net income 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 16

Equation Method (Selling price Quantity sold) – (Variable unit cost Quantity sold) – Fixed costs Operating income Let Q number of units to be sold to break even 70Q – 42Q – 84,000 0 28Q 84,000 Q 84,000 28 3,000 units 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 17

Contribution Margin Method 84,000 28 3,000 units 84,000 40% 210,000 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 18

(000) Graph Method Breakeven 378 336 294 252 210 168 126 84 42 0 e u n e v e R ts s o c l Tota Fixed costs 0 1000 2000 3000 4000 5000 Units 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 19

Target Operating Income (Fixed costs Target operating income) divided either by Contribution margin percentage or Contribution margin per unit 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 20

Target Operating Income Assume that management wants to have an operating income of 14,000. How many pairs of pants must be sold? ( 84,000 14,000) 28 3,500 What dollar sales are needed to achieve this income? ( 84,000 14,000) 40% 245,000 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 21

Learning Objective 4 Understand how income taxes affect CVP analysis. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 22

Target Net Income and Income Taxes Example Management would like to earn an after tax income of 35,711. The tax rate is 30%. What is the target operating income? Target operating income Target net income (1 – tax rate) TOI 35,711 (1 – 0.30) 51,016 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 23

Target Net Income and Income Taxes Example How many units must be sold? Revenues – Variable costs – Fixed costs Target net income (1 – tax rate) 70Q – 42Q – 84,000 35,711 0.70 28Q 51,016 84,000 Q 135,016 28 4,822 pairs of pants 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 24

Target Net Income and Income Taxes Example Proof: Revenues: 4,822 70 Variable costs: 4,822 42 Contribution margin Fixed costs Operating income Income taxes: 51,016 30% Net income 337,540 202,524 135,016 84,000 51,016 15,305 35,711 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 25

Learning Objective 5 Explain CVP analysis in decision making and how sensitivity analysis helps managers cope with uncertainty. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 26

Using CVP Analysis Example Suppose the management anticipates selling 3,200 pairs of pants. Management is considering an advertising campaign that would cost 10,000. It is anticipated that the advertising will increase sales to 4,000 units. Should the business advertise? 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 27

Using CVP Analysis Example 3,200 pairs of pants sold with no advertising: Contribution margin 89,600 Fixed costs 84,000 Operating income 5,600 4,000 pairs of pants sold with advertising: Contribution margin Fixed costs Operating income 112,000 94,000 18,000 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 28

Using CVP Analysis Example Instead of advertising, management is considering reducing the selling price to 61 per pair of pants. It is anticipated that this will increase sales to 4,500 units. Should management decrease the selling price per pair of pants to 61? 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 29

Using CVP Analysis Example 3,200 pairs of pants sold with no change in the selling price: Operating income 5,600 4,500 pairs of pants sold at a reduced selling price: Contribution margin: (4,500 19) Fixed costs Operating income 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 85,500 84,000 1,500 3 - 30

Sensitivity Analysis and Uncertainty Example Assume that the Pants Shop can sell 4,000 pairs of pants. Fixed costs are 84,000. Contribution margin ratio is 40%. At the present time the business cannot handle more than 3,500 pairs of pants. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 31

Sensitivity Analysis and Uncertainty Example To satisfy a demand for 4,000 pairs, management must acquire additional space for 6,000. Should the additional space be acquired? Revenues at breakeven with existing space are 84,000 .40 210,000. Revenues at breakeven with additional space are 90,000 .40 225,000 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 32

Sensitivity Analysis and Uncertainty Example Operating income at 245,000 revenues with existing space ( 245,000 .40) – 84,000 14,000. (3,500 pairs of pants 28) – 84,000 14,000 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 33

Sensitivity Analysis and Uncertainty Example Operating income at 280,000 revenues with additional space ( 280,000 .40) – 90,000 22,000. (4,000 pairs of pants 28 contribution margin) – 90,000 22,000 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 34

Learning Objective 6 Use CVP analysis to plan fixed and variable costs. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 35

Alternative Fixed/Variable Cost Structures Example Suppose that the factory the Pants Shop is using to obtain the merchandise offers the following: Decrease the price they charge from 32 to 25 and charge an annual administrative fee of 30,000. What is the new contribution margin? 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 36

Alternative Fixed/Variable Cost Structures Example 70 – ( 25 10) 35 Contribution margin increases from 28 to 35. What is the contribution margin percentage? 35 70 50% What are the new fixed costs? 84,000 30,000 114,000 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 37

Alternative Fixed/Variable Cost Structures Example Management questions what sales volume would yield an identical operating income regardless of the arrangement. 28x – 84,000 35x – 114,000 114,000 – 84,000 35x – 28x 7x 30,000 x 4,286 pairs of pants 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 38

Alternative Fixed/Variable Cost Structures Example Cost with existing arrangement Cost with new arrangement .60x 84,000 .50x 114,000 .10x 30,000 x 300,000 ( 300,000 .40) – 84,000 36,000 ( 300,000 .50) – 114,000 36,000 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 39

Operating Leverage Operating leverage describes the effects that fixed costs have on changes in operating income as changes occur in units sold. Organizations with a high proportion of fixed costs have high operating leverage. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 40

Operating Leverage Example Degree of operating leverage Contribution margin Operating income What is the degree of operating leverage of the Pants Shop at the 3,500 sales level under both arrangements? Existing arrangement: 3,500 28 98,000 contribution margin 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 41

Operating Leverage Example 98,000 contribution margin – 84,000 fixed costs 14,000 operating income 98,000 14,000 7.0 New arrangement: 3,500 35 122,500 contribution margin 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 42

Operating Leverage Example 122,500 contribution margin – 114,000 fixed costs 8,500 122,500 8,500 14.4 The degree of operating leverage at a given level of sales helps managers calculate the effect of fluctuations in sales on operating income. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 43

Learning Objective 7 Apply CVP analysis to a company producing different products. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 44

Effects of Sales Mix on Income Pants Shop Example Management expects to sell 2 shirts at 20 each for every pair of pants it sells. This will not require any additional fixed costs. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 45

Effects of Sales Mix on Income Contribution margin per shirt: 20 – 9 11 What is the contribution margin of the mix? 28 (2 11) 28 22 50 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 46

Effects of Sales Mix on Income 84,000 fixed costs 50 1,680 packages 1,680 2 3,360 shirts 1,680 1 1,680 pairs of pants Total units 5,040 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 47

Effects of Sales Mix on Income What is the breakeven in dollars? 3,360 shirts 20 67,200 1,680 pairs of pants 70 117,600 184,800 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 48

Effects of Sales Mix on Income What is the weighted-average budgeted contribution margin? Pants: 1 28 Shirts: 2 11 50 3 16.667 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 49

Effects of Sales Mix on Income The breakeven point for the two products is: 84,000 16.667 5,040 units 5,040 1/3 1,680 pairs of pants 5,040 2/3 3,360 shirts 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 50

Effects of Sales Mix on Income Sales mix can be stated in sales dollars: Sales price Variable costs Contribution margin Contribution margin ratio Pants Shirts 70 40 42 18 28 22 40% 55% 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 51

Effects of Sales Mix on Income Assume the sales mix in dollars is 63.6% pants and 36.4% shirts. Weighted contribution would be: 40% 63.6% 25.44% pants 55% 36.4% 20.02% shirts 45.46% 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 52

Effects of Sales Mix on Income Breakeven sales dollars is 84,000 45.46% 184,778 (rounding). 184,778 63.6% 117,519 pants sales 184,778 36.4% 67,259 shirt sales 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 53

Learning Objective 8 Adapt CVP analysis to situations in which a product has more than one cost driver. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 54

Multiple Cost Drivers Example Suppose that the business will incur an additional cost of 10 for preparing documents associated with the sale of pants to various customers. Assume that the business sells 3,500 pants to 100 different customers. What is the operating income from this sale? 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 55

Multiple Cost Drivers Example Revenues: 3,500 70 245,000 Variable costs: Pants: 3,500 42 147,000 Documents: 100 10 1,000 Total 148,000 Contribution margin 97,000 Fixed costs 84,000 Operating income 13,000 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 56

Multiple Cost Drivers Would the operating income of the Pants Shop be lower or higher if the business sells pants to more customers? The cost structure depends on two cost drivers: 1. Number of units 2. Number of customers 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 57

Learning Objective 9 Distinguish between contribution margin and gross margin. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 58

Contribution Margin versus Gross Margin Contribution income statement emphasizes contribution margin. Financial accounting income statement emphasizes gross margin. 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 59

End of Chapter 3 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 60