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Topic 4 Cost-Volume-Profit Analysis & Break-Even Point Analysis

This document discusses cost-volume-profit analysis and break-even analysis. It covers key concepts like contribution margin, break-even point, margin of safety, operating leverage, and how these analyses can be applied under different scenarios and assumptions. Several examples of cost-volume-profit analysis are also provided.

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181 views

Topic 4 Cost-Volume-Profit Analysis & Break-Even Point Analysis

This document discusses cost-volume-profit analysis and break-even analysis. It covers key concepts like contribution margin, break-even point, margin of safety, operating leverage, and how these analyses can be applied under different scenarios and assumptions. Several examples of cost-volume-profit analysis are also provided.

Uploaded by

digididoghakdog
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We take content rights seriously. If you suspect this is your content, claim it here.
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Topic 4: Cost-Volume-Profit Analysis / Break-even Point Analysis

Cost Volume Profit Analysis


Cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume,
and profit by focusing their attention on the interactions among the prices of products, volume of activity,
per unit variable costs, total fixed costs, and mix of products sold. It is a vital tool used in many business
decisions such as deciding what products to manufacture or sell, what pricing policy to follow, what
marketing strategy to employ, and what type of productive facilities to acquire. The contribution income
statement is helpful to managers in judging the impact on profits of changes in selling price, cost, or
volume.
Assumptions:
1. A firm’s total revenue changes in direct proportion to changes in its unit sales volume. That is, the
average sales price per unit of product is constant.
2. Total costs can be separated into fixed costs and variable costs.
3. Total variable costs change in direct proportion to changes in sales volume. That is, the average
variable cost per unit remains constant over the relevant range.
4. Total fixed costs (per month or per year) remain constant over the range of sales volume being
considered.
5. Sales mix remains constant over the range of sales volume being considered.
6. Sales volume equals production volume. That is, inventory levels remain constant.

Contribution Margin
• It is known as marginal income or profit volume.
• It is used to recover fixed expenses and any excess are treated as profits.
• CM = Sales – Variable Cost
• CM per Unit = CM / Total Units
• CM Ratio = CM / Sales = CM per Unit / Sales per Unit = Net Income Ratio + Fixed Cost Ratio

Break-even Pont
• A situation wherein Total Contribution Margin equals to Total Fixed Costs
• Breakeven Pont (Expressed in Units) = Total Fixed Costs / Unit Contribution Margin
• Breakeven Point (Expressed in Amount) = Total Fixed Costs / CM Ratio = Breakeven Units X
Sales Price
Variable Expense Ratio
• Ratio of variable expenses to sales
• Sales 100% = CM Ratio + Variable Expense Ratio

Margin of Safety
• Excess of sales over breakeven that will bring fort profit
• All contribution margin derived from the margin of safety is regarded as profit
• Margin of Safety = Total Sales – Breakeven Sales
• Margin of Safety Ratio = Margin of Safety / Sales = Net Income Ratio / CM Ratio
• Breakeven Ratio = Breakeven Sales / Sales
• Sales 100% = Breakeven Ratio + Margin of Safety Ratio
• Fixed Cost Ratio = Breakeven Sales % X CM Ratio

Scenarios Under CVP Analysis


I. Sales with Desired Profit
• Sales (in units) = (Total Fixed Cost + Target Profit) / CM per Unit
• Sales (in amount) = (Total Fixed Cost + Target Profit) / CM Ratio
• Sales (in amount) = Total Fixed Cost / (CM Ratio – Target Profit % or ROS)
II. Effects on Income Tax on Break-even Sales
• At break-even point, income taxes are irrelevant or have no effect on the break-even sales
because there are no profits at this level of sales.
• Income tax will increase the desired sales volume if it is included in the computation of a target
profit.
• Sales (in amount) = (Total Fixed Cost + Target Profit / (1-Tax Rate)) / CM Ratio
III. Sales with Multiple Cost Drivers
• Breakeven Point = ((Cost Driver X Activity) + (Cost Driver X Activity) + Other Fixed Cost) / CM%
or CM per Unit
• There are certain costs that may be variable in nature but whose cost driver may not be based on
the units produced but on other cost drivers.
IV. Breakeven Analysis Under Absorption Costing
• Breakeven Point (N) = (Total Fixed Costs – Fixed Manufacturing Cost Per Unit (Total Units
Produced – N)) / CM per Unit
V. CVP Indifference Point
• CVP can compare alternative cost structures or selling prices
• Indifference point between alternative is the level of sales in units or sales peso where the profits
of the alternatives are equal
• Qty = Difference in Fixed Cost / Difference in CM
• The product/process with the higher CM per Unit is favorable if demand is greater than
indifference point.
• The product/process with the lower fixed cost is favorable if demand is less than the indifference
point.
VI. CVP Analysis with Step Fixed Costs
• Fixed costs vary after a certain range of activity level has been achieved
• CVP involving step fixed costs, breakeven point for each level activity should be determined
individually.
• If the breakeven point does not fall within the specified range of activity level, then, we need to
calculate the breakeven point using the next range of activity levels until such amount falls within
the specified range.

Operating Leverage
• Operating leverage results from the presence of fixed operating costs in a firm’s income stream.
The extent of the presence of fixed operating costs in a firm’s income stream is measured by the
degree of operating leverage (DOL).
• When sales increase, the one with a higher leverage will have a higher net income.
• Measure of how sensitive net income is to % change in sales
• Serve as a multiplier effect as it measures at a given level of sales, how a percentage change in
sales will affect profit
• Degree of Operating Leverage (DOL) = CM / NI
• % Change in Sales X Operating Leverage = % Change in Net Income
• Relationship between Operating Leverage and Margin of safety: inversely proportional to each
other => Margin of Safety = 1 / Operating Leverage

Sales Mix Analysis


• Breakeven analysis involving more than one product or involving multi-products
A. Independent Products Scenario
o Breakeven Units = Total Fixed Cost / Weighted CM per Unit
o Weighted CM per unit is obtained by multiplying the individual Sales Mix Proportions to
the corresponding CM per Unit.
o Weighted CM% = Total CM / Total Revenues
B. Package (Composite) Products
o Certain products are sold in packages or components with a corresponding mix or ratio
that has to e observed.
o Breakeven Units = Total Fixed Cost / Composite CM per Unit
o Composite Unit is computed as Sum of CM per Unit multiply by Product Mix

CVP and JIT


• If a firm adopted JIT, the variable cost per unit sold is reduced, and fixed costs are increased.
• Direct labor, for example, is now viewed as fixed instead of variable. In fact, the emphasis on total
quality and long-term purchasing makes the assumption even more true that direct material cost
is strictly proportional to units produced (because waste, scrap, and quantity discounts are
eliminated).
• Other unit-based variable costs such as power and sales commissions also persists.
• The batch-level variable is gone (in JIT, the batch is one unit).
• Cost Equation for JIT: Total Cost = Fixed Costs + (Unit Variable Cost X Units) + (Engineering Cost
X Number of Engineering Hours)

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