LECTURE NO. 5 CVP ANALYSIS

LESSON OBJECTIVES

1. Understand & explain what CVP business decisions it can aid 2. Appreciate the assumptions of CVP analysis 3. Calculate & Explain the significance of: • Contribution Margin • Break Even Point • Margin of Safety 4. Prepare and explain a CVP graph 5. Use CVP analysis to: • Plan Profits • Determine volume – given profit target • Perform Sensitivity Analysis 6. Incorporate Income Tax Rates in CVP analysis 7. Use CVP analysis in a multi product environment

CVP ANALYSIS

C V P - COST - VOLUME - PROFIT

1

5 KEY ELEMENTS IN CVP ANALYSIS

• Uses basic concepts of cost behavior: Fixed Cost, Variable Cost, Linear Relationship etc. • CVP looks at the interrelationship between 5 key elements as they impact Operating Income UNIT SELLING PRICE

VOLUME / ACTIVITY

SALES / PRODUCT MIX

UNIT VARIABLE COST

TOTAL FIXED COST

ASSUMPTIONS OF CVP

• Cost and Revenue behavior - linear throughout the relevant range • All costs are either variable or fixed • Changes in activity are the only factors that affect costs • All units produced are sold • When more than one type of product is sold, the sales mix will remain constant

BUSINESS APPLICATION OF CVP

Decisions where CVP analysis used • Break even point • Sales Level to achieve target profit • Optimum sales / product mix • Impact of changes in any of the 5 key elements • Impact of substituting Variable Cost with Fixed cost

2

Contribution Margin

What is Contribution Margin:

• Revenue less Variable Cost • The Contribution Margin is used to cover Fixed Costs • In profitable organizations the following exists • Contribution Margin > FC + VC Formula to Calculate Contribution Margin: Contribution Margin = Sales Revenue – Variable Costs

Contribution Margin

Contribution Income Statement: (the starting point to do CVP analysis) Ø A statement for internal use Ø Classifies costs and expenses as fixed or variable Ø Reports contribution margin in the body of the statement. Ø Reports the same net income as the traditional income statement

CVP INCOME STATEMENT

Davann Company Variable Costing Income Statement for the Year Ended December 31, 20x5 Sales Variable costs: Manufacturing Selling costs Contribution margin Fixed costs: Manufacturing Selling Administration Income before income taxes Income taxes (40%) Net income *Sales – 1800 tonnes $900,000 315,000 180,000 495,000 405,000 90,000 112,500 45,000 247,500 157,500 63,000 $ 94,500

3

CVP INCOME STATEMENT

Example

Vargo Video Company produces DVD players. Relevant data for June 2005: Unit selling price of DVD player Unit variable costs Total monthly fixed costs Units sold $500 $300 $200,000 1,600

CONTRIBUTION MARGIN PER UNIT

Ø Contribution margin is available to cover fixed costs and to contribute to profit Ø Formula for contribution margin per unit: Unit Selling Price

–

Unit Variable Costs

=

Contribution Margin per Unit

Ø Example: Computation for Vargo Video

Unit Selling Price $500 Unit Variable Costs $300 Contribution Margin per Unit $200

–

=

CONTRIBUTION MARGIN RATIO

Ø Shows the percentage of each sales dollar available to apply toward fixed costs and profits

Contribution Margin per Unit

÷

Unit Selling Price

=

Contribution Margin Ratio

Ø Example: Computation for Vargo Video

Contribution Margin per Unit S200

÷

Unit Selling Price $500

=

Contribution Margin Ratio 40%

4

Contribution Margin Ratio - Example

Ratio helps to determine the effect of changes in sales on net income

BREAK-EVEN ANALYSIS

Process of finding the break-even point Break-even point

§ Level of activity at which: Total Revenues equal Total Costs § Can be computed or derived • from a mathematical equation • by using unit contribution margin • from a cost -volume-profit (CVP) graph § Expressed either in sales units or in salesdollars (both fixed and variable)

BREAK-EVEN...