Text Preview

3

Overview

Cost-Volume-Profit Analysis

revenues and total costs behave. If decisions can be significantly improved, managers should choose a more complex approach that, for example, uses multiple cost drivers and nonlinear cost functions. 3. Because managers want to avoid operating losses, they are interested in the breakeven point calculated using CVP analysis. The breakeven point is the quantity of output sold at which total revenues equal total costs. There is neither a profit nor a loss at the breakeven point. To illustrate, assume a company sells 2,000 units of its only product for $50 per unit, variable cost is $20 per unit, and fixed costs are $60,000 per month. Given these conditions, the company is operating at the breakeven point: Revenues, 2,000 × $50 Deduct: Variable costs, 2,000 × $20 Fixed costs Operating income $100,000 40,000 60,000 $ -0-

This chapter explains a planning tool called costvolume-profit (CVP) analysis. CVP analysis examines the behavior of total revenues, total costs, and operating income (profit) as changes occur in the output level, selling price, variable cost per unit, and/or fixed costs of a product or service. The reliability of the results from CVP analysis depends on the reasonableness of the assumptions. The Appendix to the chapter gives additional insights about CVP analysis; it illustrates decision models and uncertainty. Review Points 1. CVP analysis is based on several assumptions including: a. Changes in the level of revenues and costs arise only because of changes in the number of product (or service) units produced and sold (that is, the number of output units is the only driver of revenues and costs). b. Total costs can be separated into a fixed component that does not vary with the output level and a component that is variable with respect to the output level. c. When represented graphically, the behaviors of both total revenues and total costs are linear (straight lines) in relation to the output level within the relevant range (and time period). d. The analysis either covers a single product or assumes that the proportion of different products when multiple products are sold will remain constant as the level of total units sold changes. 2. Even though CVP assumptions simplify real-world situations, many companies have found CVP relationships can be helpful in making decisions about strategic and long-range planning, as well as decisions about product features and pricing. Managers, however, must always assess whether the simplified CVP relationships generate sufficiently accurate predictions of how total

The breakeven point can be expressed two ways: 2,000 units and $100,000 of revenues. 4. Under CVP analysis, the income statement above is reformatted to show a key line item, contribution margin: Revenues, 2,000 × $50 Variable costs, 2,000 × $20 Contribution margin Fixed costs Operating income $100,000 40,000 60,000 60,000 $ -0-

This format, called the contribution income statement, is used extensively in this chapter and throughout the textbook. 5. Contribution margin can be expressed three ways: in total, on a per unit basis, and as a percentage of revenues. In our example, total contribution margin is $60,000. Contribution margin per unit is the difference between selling price and variable cost per unit: $50 − $20 = $30. Contribution margin per unit is also equal to contribution margin divided by the number of units sold: $60,000 ÷ 2,000 = $30. Contribution margin percentage (also called contribution

COST-VOLUME-PROFIT ANALYSIS

23

margin ratio) is contribution margin per unit divided by selling price: $30 ÷ $50 = 60%; it is also equal to contribution margin divided by revenues: $60,000 ÷ $100,000 = 60%. This contribution margin percentage means that 60 cents in contribution margin is gained for each $1 of revenues. 6. In our example, compute the breakeven point (BEP) in units and in revenues as follows: Total fixed costs Contributi on...