cost accounting -profit analysis chapter 1

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1. Lecture 5 Ch. 3 Cost-Volume-Profit analysis 1

2. 2 In today’s lecture: 1- Cost Accounting definition Financial players in the organization In today’s lecture: 1- CVP definition 2- Break-even analysis: Graph Illustration 3- Break-even analysis: Equations calculation 4- Target Operating Income 5- Margin of safety 6- GOCS and COGM exercises Ch. 3 Cost-Volume-Profit analysis

3. 1- CVP definition Cost-volume-profit (CVP) analysis studies the behavior and relationship between total revenues , total costs , and income as changes occur in the units sold , the selling price , the variable cost per unit, or the fixed costs of a product. Cost-Volume-Profit Uses: CVP provides structure to answer a variety of “what-if” scenarios . “What” happens to profit “if”: Selling price changes. Volume (of sales or production) changes. Cost structure changes. Variable cost per unit changes. Fixed cost changes. Cost-Volume-Profit Assumptions: Changes in volume of production/sales are the sole cause for cost and revenue changes. Total costs consist of fixed costs and variable costs. Revenue and costs behave and can be graphed as a linear function (a straight line). Selling price, variable cost per unit, and fixed costs are all known and constant . 3 Ch. 3 Cost-Volume-Profit analysis

4. 1- CVP definition (Cont’d) Cost-Volume-Profit ( CVP ) can be used to calculate: (1) Break-even point, (2) Target operating income, (3) Margin of safety. Break-even analysis is a method used to calculate the amount of sales (both in units and dollars) required to achieve zero profit or loss from operations. This analysis is mainly used to make business plans, sales budgets and pricing alterations. To make those calculations, three values are needed: 4 Ch. 3 Cost-Volume-Profit analysis Fixed costs : In the short-term and within the relevant range, they are Fixed in total as sales volume or production volume vary Variable costs : Varies in total as sales volume or production volume vary Selling price : The price at which the unit is sold Contribution Margin : Is the difference between the selling price and the variable cost

5. 2- Break-even analysis: Graph Illustration (Cont’d) In the graph method , we represent total costs and total revenues graphically. We need only two points to plot the line representing each of them. To draw the graph, we need : 1-Total costs line : The total costs line is the sum of fixed costs and variable costs. 2-Total revenues line : One convenient starting point is $0 revenues at 0 units sold. 5 Ch. 3 Cost-Volume-Profit analysis

6. 6 Ch. 3 Cost-Volume-Profit analysis Number of units $US Dollars 2- Break-even analysis: Graph Illustration Two values are needed: (1)Total cost, (2) Total Revenues

7. 7 Ch. 3 Cost-Volume-Profit analysis Number of units $US Dollars 2- Break-even analysis: Graph Illustration (Cont’d) Two values are needed: (1)Total cost, (2) Total Revenues ( sp /u =$25)

8. 3- Break-even analysis: Equations calculation We can calculate the break-even point in Units and in dollars, without having to draw a graph: a) Break-even point in Units We can calculate the break-even point in units through dividing Total Fixed costs by Contribution Margin per unit b) Break-even point in Dollars We can calculate the break-even point in dollars in two ways, the first of which relies on the previous calculation of break-even point in Units. This is where: 8 Ch. 3 Cost-Volume-Profit analysis Break-even point in Units = Total Fixed cost Contribution Margin per unit Break-even point in Dollars = Break-even point in Units x Selling Price per unit

9. 3- Break-even analysis: Equations calculation (Cont’d) b) Break-even point in Dollars ( Cont’d ) The second way to calculate the break-even point in dollars directly without relying on any previous calculations step is: Remember that : Contribution Margin per unit = Selling price - Variable cost per unit. T. Contribution margin = Contribution margin per unit * Number of units sold Contribution margin = Contribution margin percentage * Revenues (in dollars) 9 Ch. 3 Cost-Volume-Profit analysis Break-even point in Dollars = Total Fixed cost Contribution Margin Ratio Contribution Margin Ratio = Contribution Margin Selling Price

10. Practice question The following information belongs to Green Grass industries. Fixed Cost : $150,000 Variable cost per unit: $50 Selling price per unit $125 10 Ch. 3 Cost-Volume-Profit analysis Team A Calculate the break-even point in Units Team B Calculate the break-even point in Dollars Break-even point in Units = $150,000/($125-50) = 2000 Units Break-even point in Dollars = $150,000/($125-50/125) = $250,000

11. 4- Target Operating Income We illustrate target operating income calculations by asking the following question: How many units must Emma sell to earn an operating income of $1,200? Selling price per unit is $200, variable cost per unit is $120, fixed costs are $2,000. Option 1: We denote by Q the unknown quantity of units Emma must sell to earn an operating income of $1,200, and substitute the given values into equation 1, we get: Option 2: 11 Ch. 3 Cost-Volume-Profit analysis

12. 4- Target Operating Income We illustrate target operating income calculations by asking the following question: How many units must Emma sell to earn an operating income of $1,200? Selling price is $200, variable cost per package is $120, fixed costs are$2,000. Option 3: To calculate the amount that needs to be sold in units , use: To calculate the amount that needs to be sold in dollars , use: 12 Ch. 3 Cost-Volume-Profit analysis

13. 4- Target Operating Income Practice question: Brooke Motors is a small car dealership. On average, it sells a car for $27,000, which it purchases from the manufacturer for $23,000. Each month, Brooke Motors pays $48,200 in rent and utilities and $68,000 for salespeople’s salaries. In addition to their salaries, salespeople are paid a commission of $600 for each car they sell. Brooke Motors also spends $13,000 each month for local advertisements. Givens: b) How many cars must be sold each month to reach a target monthly operating income of $85,000? 13 Ch. 3 Cost-Volume-Profit analysis Sp /Car = $27,000 VC/Car = ($23,000 + 600) = $23,600 Total Fixed Costs = 48,200 + 68,000 + 13,000 = $129,200 a) How many cars must Brooke Motors sell each month to break even? BEP in units = $ 129,200 = 129,200 = ( 27,000 – 23,600 ) 3,400 38 cars Units to achieve target income = $ 129,200 + 85,000 = 3,400 63 cars

14. 5- Margin of safety Margin of safety is an indicator of risk, the margin of safety (MOS), measures the distance between budgeted sales (units or dollars) and breakeven sales (units or dollars).  MOS in units = Budgeted units or Actual units – BEP units  MOS in dollars = Budgeted or Actual sales revenues – BEP revenues Practice : Suppose Doral Corp.’s breakeven point is revenues of $1,980,000. Fixed costs are $660,000 and the selling price per unit is $24 and the variable cost/unit is $16. Suppose 95,000 units (actual) are sold. a) Compute the margin of safety in units? MOS in units = 95,000 – 82,500 = 12,500 units b) Compute the margin of safety in dollars? 14 Ch. 3 Cost-Volume-Profit analysis BEP in units = 660,000 = (24-16) 82,500 units Actual sales = 95,000 units x $24 = $2,280,000 MOS in dollars = 2,280,000 – 1,980,000 = $300,000