CVP Analysis-Group 5 Presentation Final.pptx

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1. Addis Ababa University College of Business and Economics Department of Management Executive Master of Business Administration Financial and Managerial Accounting Group 5 Members and Presenters: Samrawit Bogale Tewodros Bezuneh Yimam Seid Zelalem Mehretu Zertihun Teshome January 2022

2. CHAPTER 9 COST-VOLUME-PROFIT (CVP) ANALYSIS

3. Lessons to be learned at the end of the chapter Explain how fixed, variable, and semi-variable costs respond to changes in the volume of business activity Understand the effect of cost structure on decisions Compute contribution margin and explain its usefulness Determination of break-even point Use of cost-volume-profit (CVP) analysis to make decisions. Understand the assumptions and limitations of CVP analysis.

4. 1) COST-VOLUME-PROFIT (CVP) ANALYSIS 1.1) Introduction to CPV Analysis Cost-Volume-Profit [CVP] analysis is an analytical tool for studying the relationship between volume, cost, prices, and profits. An understanding of these relationships is essential in developing plans and budgets for future business operations. The concepts of CPV analysis may be applied to the business as a whole; to individual segments of the business such as a division, a branch, or a department; or to a particular product line.

5. 1.2) Usage of CPV Analysis CPV Analysis can be used in the following areas: To forecast volume of business enough for a desired profits, To set budgets, To evaluate performance, To set pricing, To determine overheads, To make decision such as suitable sales mix, dropping of a product, etc

6. 2) COST BEHAVIORS Basic cost categories involved in CVP analysis are; 2.1 Fixed Costs 2.2 Variable Costs 2.3 Semi-Variable Costs For these categories a manager seeks some measurable base or activity that allows to increase or decrease to be matched with increases or decreases in the costs. This is called Activity Base or Cost Driver. So, once we identify the activity base, we’ll next classify operating costs into one of three broad categories: fixed costs , variable costs , and semi-variable costs (mixed costs) .

7. 2.1 Fixed Costs Fixed costs are those costs and expenses that do not change significantly in response to changes in an activity base. These costs will be incurred even if no units are produced Depending on the nature of a particular business, fixed costs can include administrative and executive salaries, property taxes, rents and leases, and many types of insurance protection.

8. Fixed cost per unit  decreases with increase in production. This is due to economies of scale . Total Fixed Cost $30,000 $30,000 $30,000 ÷ Units Produced 5,000 10,000 15,000 Fixed Cost per Unit $6.00 $3.00 $2.00

9. Economies of scale; The decrease in fixed cost per unit at higher levels of activity represents a more efficient use of the company’s productive assets. Example: aircraft, automobile manufacturing plant . In general, most businesses can reduce unit costs by using their facilities more intensively and these savings are called economies of scale

10. 2.2 Variable Costs A variable cost is one whose total rises or falls in approximate proportion to changes in an activity base. This means that total variable costs increase when more units are produced and decreases when less units are produced. Examples of variable costs include: raw materials, cost of labor, packaging, commission, and etc

11. Variable cost per unit  is constant. Total Variable Cost $10,000 $20,000 $30,000 ÷ Units Produced 5,000 10,000 15,000 Variable Cost per Unit $2.00 $2.00 $2.00

12. 2.3 Mixed /Semi-Variable Costs Mixed costs  or semi-variable costs have properties of both fixed and variable costs due to the presence of both variable and fixed components in them. An example of mixed cost is telephone expense because it usually consists of a fixed component such as line rent as well as variable cost charged per minute cost. Since mixed cost figures are not useful in their raw form, therefore they are split into their fixed and variable components by using cost behavior analysis techniques such as  High-Low Method .

13. Summary of Behavior of each Cost Categories Category Fixed Costs Variable Costs Mixed Costs In terms of Total cost Constant Changes proportionately with output Changes with output but not at equal proportion Cost per unit Decreases with increase in output Constant Decreases with but lesser proportion with the Fixed costs

14. 3) BREAK-EVEN POINT ANALYSIS The break-even point is when total revenues and total costs are equal, that is, there is no profit or loss made. Total Revenue = Total Costs Knowing the break-even sales volume can be of vital importance, especially to companies deciding whether to introduce a new product line, build a new plant or, in some cases, remain in business. There are three methods for ascertaining the break-even point:  3.1) The equation method, 3.2) The contribution margin method, and 3.3) The graphical method.

15. 3.1) The equation method Total revenue (TR) Unit selling price (USP) × Quantity sold (Q) TR = USP × Q Total cost (TC) [Unit variable cost (UVC) × Total quantity (Q)] + Total fixed costs (FC) TC = (UVC × Q) + FC Profit Equation (P) Profit = Total revenue – Total costs P = [( USP × Q)] – [(UVC × Q) + FC] P = Q(USP – UVC) - FC

16. E.g. Take a given XYZ Company Price per unit = $70 Variable cost per unit = $30 Total fixed cost = $50,000 P = Q(USP – UVC) – FC 0 = Q(70-30)-50,000 50,000 = Q(40) Q = 50,000 ÷ 40 Q = 1,250 units -If the Co. sells less than 1,250 units = make loss -If the Co. sells exactly 1,250 units = will break-even -If the Co. sells more than 1,250 units = make profit

17. 3.2) The contribution margin method The contribution margin is simply the amount by which revenue exceeds variable costs. SnowGlide Company Statement of Profit or Loss For the month of November 2021 Total Per unit Sales (900 units @ $ 90) $ 81,000 $ 90 Less : Variable costs (32,400 ) 36 Contribution margin 48,600 $ 54 Less : Fixed costs (37,800 ) Operating income $ 10,800

18. Calculating break-even point using the contribution margin method has two equations (formulae): Break-even point (Units) Fixed costs Unit contribution margin Break-even point (Sales Dollars) Fixed costs Contribution margin ratio

19. Now let us see how the previous formulae can be applied in the case of SnowGlide : Contribution margin = Total Revenue - Total variable cost (CM) (TR) (TVC) = 81,000 - 32,400 = $ 48,600 Unit contribution margin = Unit selling – Unit variable (UCM) price (USP) cost (UVC) = 90 - 36 = $ 5 4/unit continued…….

20. ……continued Contribution margin = UCM = 54 = 60% ratio USP 90 = CM = 48,600 = 60% TR 81,000 BEP (in units) = Fixed costs UCM = 37,800 54 = 700 units BEP (in sales dollars) = Fixed costs_______ Contribution margin ratio = 37,800 60% = $ 63,000

21. 3.3) The graphical method With the graphical method, the total costs and total revenue lines are plotted on a graph, $ is shown on the y-axis and units are shown on the x-axis The point where the total cost and revenue lines intersect is the break-even point. First we draw the total revenue line having a slope of unit selling price, Secondly, we draw fixed cost line which is parallel to the x-axis, and Lastly, we draw the total cost line with slope of unit variable cost.

22. 4) DETERMINATION OF SALES VOLUME REQUIRED TO EARN A DESIRED LEVEL OF OPERATING INCOME The concept of contribution margin can be taken one step further to find not only the unit sales volume needed to break even but also to determine the sales volume needed to achieve any desired level of operating income. The Formula to use:- Target sales volume (Units) Fixed costs + Target profit Unit contribution margin Target sales volume ( Sales Dollars ) Fixed costs + Target profit Contribution margin ratio

23. Example; Take a case of SnowGlide If SnowGlide want to earn a monthly operating income of $5,400.00. Hence, how many snowboards must SnowGlide must sell to earn that amount of Operating Income? Sales volume (in units) = Fixed costs + Target profit Unit contribution margin = 37,800+5,400 54 = 800 units Sales volume = Fixed costs + Target profit (in sales dollars) Contribution margin ratio = 37,800+5,400 60% = $ 72,000

24. 5) MARGIN OF SAFETY Margin of Safety is The dollar amount by which actual sales volume exceeds the break-even sales volume. Margin of Safety = Actual sales – Break-even sales In today’s volatile economy, it is important for managers to understand the extent to which their companies can endure a downturn in sales. Illustration ; Take a case of SnowGlide’s monthly sales volume required to break even is $ 63,000.00, then if the company's sale during the next month is $ 72,000.00. Then Margin of safety: $72,000-$63,000 = $ 9,000.00

25. The margin of safety can also be used as a quick means of estimating operating income at any projected sales level. This relationship is summarized as follows. Operating Income = Margin of Safety × Contribution Margin Ratio The rationale for this formula stands from the fact that the margin of safety represents sales dollars in excess of the break-even point. Therefore, if fixed costs have already been covered, the entire contribution margin of these sales increases the operating income. Illustration; In the last example we assumed that the SnowGlide’s sales will be $72,000.00 during the next month after Break even and the break-even sales volume was $63,000. Hence, the margin of safety is $72,000-$63,000=$9,000. Thus, the projected operating income as computed using the above formula will be; Operating Income= $9,000 × 60%= $ 5,400

26. Continued… WHAT CHANGE IN OPERATING INCOME DO WE ANTICIPATE? Contribution margin ratio can also be used to estimate the change in operating income caused by a change in sales volume As stated in the previous example, the contribution margin ratio for SnowGlide is 60%. Thus, once break-even is reached, every additional dollar of sales increases SnowGlide’s operating income by 60 cents. Conversely, a $1 sales decline lowers profitability by 60 cents. This relationship may be summarized as; Change in Operating Income = Change in Sales Volume × Contribution Margin Ratio Therefore, if SnowGlide estimates a $5,000 increase in monthly sales after break-even, it would anticipate a corresponding increase in operating income of $3,000 ($5,000 × 60%).

27. 6) BUSINESS APPLICATIONS OF CVP The use of cost-volume-profit analysis is not limited to accountants. On the contrary, it provides valuable information to many individuals throughout an organization. Cost-volume-profit relationships are widely used during the budget process to set sales targets, estimate costs, and provide information for a variety of decisions. To illustrate, let us consider several ways in which cost-volume-profit relationships might be used by the management of SnowGlide Company . We now will examine the concerns of three SnowGlide executives

28. Director of Advertising Assume that SnowGlide is currently selling approximately 900 snowboards each month. In response to the new market strategy, the company’s director of advertising is asking for an increase of $1,500 in her monthly budget. She plans to use these funds to advertise in several East Coast trade publications. From her experience, she is confident that the advertisements will result in monthly orders from East Coast distributors for 500 boards . She wishes to emphasize the impact of her request on the company’s operating income . Analysis As the proposed advertising is viewed as a fixed cost, this expenditure does not affect SnowGlide’s contribution margin ratio of 60 percent. Based on projected monthly sales of $126,000 (1,400 units × $90), the projected monthly operating income can be determined as follows:

29. The target income figure is $25,500 higher than the present monthly figure of $10,800 ($36,300 − $10,800 = $25,500). Thus, the director of advertising believes that her request for an additional $1,500 is well justified. SnowGlide Company Statement of Profit or Loss For the month of November 2021   Total Per unit Total Per unit Unit Sales (900 units @ $ 90) $ 81,000 $ 90 $ 126,000 $ 90 1400 Less : Variable costs (32,400 ) 36 (50,400 ) 36 1400 Contribution margin 48,600 $ 54 75,600 $ 54   Less : Fixed costs (37,800 )   (39,300 )     Operating income $ 10,800   $ 36,300    

30. Plant Manager SnowGlide’s plant manager does not completely agree with the advertising director’s projections. He believes that the increased demand for the company’s product will initially put pressure on the plant’s production capabilities. To cope with the pressure, he asserts that many factory workers will be required to work excessive overtime hours, causing an increase in direct labor costs of approximately $1.80 per unit . Assuming that he is correct, he wants to know the sales volume in units required to achieve the advertising director’s projected monthly income figure of $36,300. Analysis Holding the selling price at $90 per unit, the $1.80 overtime premium will reduce SnowGlide’s current contribution margin from $54 per unit to $52.20 per unit as follows.

31. If the director of advertising receives a monthly increase of $1,500 in her budget, and if a $36,300 income target is established, the number of units that must be sold is computed as follows. SnowGlide Company Statement of Profit or Loss For the month of November 2021   Total Per unit Total Per unit Unit Sales (900 units @ $ 90) $ 81,000 $ 90 $ 130,320 $ 90 1448 Less : Variable costs (32,400 ) 36 (54,720 ) 37.80 1448 Contribution margin 48,600 $ 54 75,600 $ 52.20   Less : Fixed costs (37,800 )   (39,300 )     Operating income $ 10,800   $ 36,300    

32. Vice President of Sales The vice president of sales isn’t convinced that an increase in the monthly advertising budget of $1,500 will yield sales of 500 units per month in the East Coast region. Her estimate is more conservative, at 350 units per month (for total monthly sales of 1,250 units) . Assume that the monthly advertising budget is increased by $1,500, and that direct labor costs actually do increase by $1.80 per unit because of the overtime premium required to meet increased production demands. If the vice president of sales is correct regarding her 1,250-unit projection, she wants to know the extent to which the company would have to raise its selling prices (above the current price of $90 per unit) to achieve a target monthly income figure of $36,300 . Analysis If 1,250 units are sold each month instead of 1,400 units, the contribution margin per unit must increase in order for the company to achieve the same target income (taking the increases in advertising and direct labor costs into consideration). Once again, we use the fol lowing formula.

33. The unit contribution margin is computed as follows SnowGlide Company Statement of Profit or Loss For the month of November 2021   Total Per unit Total Per unit Unit Sales (900 units @ $ 90) $ 81,000 $ 90 $ 122,850 $ 98.28 1250 Less : Variable costs (32,400 ) 36 (47,250 ) 37.80 1250 Contribution margin 48,600 $ 54 75,600 $ 60.48   Less : Fixed costs (37,800 )   (39,300 )     Operating income $ 10,800   $ 36,300    

34. 7) ADDITIONAL CONSIDERATIONS IN CVP In practice, the application of cost-volume-profit analysis is often complicated by various factors, including; 7.1) different products with different contribution margins, 7.2) determining semi variable cost elements, and 7.3) assumptions of cost-volume-profit analysis.

35. Continued----ADDITIONAL CONSIDERATIONS IN CVP 7.1 CVP ANALYSIS WHEN A COMPANY SELLS MANY PRODUCTS In our previous illustration; SnowGlide sells only a single product, snowboards. However, most companies sell a mix of many different products. The term sales mix often is used to describe the relative percentages of total sales provided by different products and those different products may usually have different contribution margin ratios. Often Managers apply cost-volume relationships to the business viewed as a whole. For this purpose, Managers use the contribution margin ratio reflecting the company’s current sales mix .

36. Continued-- ADDITIONAL CONSIDERATIONS IN CVP Illustration; International Printer Machines (IPM) builds three computer printer models: Inkjet, Laser, and Color Laser. Information for these three products is as follows: Total annual fixed costs are $5,000,000. Assume the sales mix remains the same at all levels of sales.   Inkjet Laser Color Laser Total Selling price per unit $250 $400 $1,600   Variable cost per unit $100 $150 $   800   Contribution margin per unit $150 $250 $800   Expected unit sales (annual) 12,000 6,000 2,000 20,000 Sales mix 60% 30% 10% 100%

37. Continued-- ADDITIONAL CONSIDERATIONS IN CVP Q1- How many printers in total must be sold to break even? The break even point of the sales mix computed using the break even point formula Break even Point = $5,000,000 + $0 (Units) ($150 x 0.60)+($250 x 0.30)+($800 x 0.10) = $5,000,000 = 20,408 units $245 Total fixed costs + Target Profit Weighted average contribution margin per unit

38. Continued-- ADDITIONAL CONSIDERATIONS IN CVP Q2- How many units of each printer must be sold to break even? As calculated previously, 20,408 printers must be sold to break even. Using the sales mix provided, the following number of units of each printer must be sold to break even: Inkjet: 12,245 units = 20,408 x 0.60 Laser : 6,122 units = 20,408 x 0.30 Color Laser : 2,041 units = 20,408 x 0.10 20,408 units

39. Continued-- ADDITIONAL CONSIDERATIONS IN CVP Q3- How much must IPM have in total sales dollars to break even? The break even point of the sales mix computed using the break even point formula Total fixed costs + Target Profit Weighted average contribution margin ratio Weighted average contribution margin per unit Weighted average unit selling price Weighted average Contribution margin ratio = ($150 x 0.60)+($250 x 0.30)+($800 x 0.10) ($250 x 0.60)+($400 x 0.30)+($1600 x 0.10) 245 430 = = 56.97674419%

40. Continued-- ADDITIONAL CONSIDERATIONS IN CVP Break even Point = $5,000,000 + $0 (sales dollar) 56.97674419% = $ 8,775,510 Total fixed costs + Target Profit Weighted average contribution margin ratio

41. Continued-- ADDITIONAL CONSIDERATIONS IN CVP 7.2 Determining semi-variable cost elements Up to now, through our illustrations, we were dealing on Costs which are initially identified as Variable and Fixed in regard to change in volume of business. However in practice we may face with a semi-variable Costs. Semi-variable costs are costs which have both fixed and a variable portions. Hence, for the purpose of analysis we need to estimate the fixed and variable components. There could be several mathematical techniques that may be used to perform this task, but for this lecture we will focus on one approach called the high-low method.

42. Continued-- ADDITIONAL CONSIDERATIONS IN CVP High-Low method Example; The administrative cost below has a fixed and a variable portion that varies with the level of production. The information pertaining to the first six months of the year is shown: Total Units Total Administrative Produced Costs January ......................900 $ 25,060 February ..................... 850 25,040 March ........................ 925 25,183 April ............................ 950 25,280 May ............................ 875 25,140 June ........................... 910 25,194

43. Continued--- High Low Method Computation ; Step-1 : Find the variable portion of total administrative costs. To find that, we relate the change in cost to the change in the activity base between the highest and the lowest months of production activity Total Units Total Administrative Produced Costs April (highest) ............. 950 $25,280 February (lowest)........ 850 25,040 Changes .................... 100 Units $ 240 Hence, Notice that a 100-unit increase in production results in a $240 increase in administrative costs. Therefore, the variable element of this cost may be estimated at $240 per 100 units, i.e. $2.40 per unit

44. Continued--- Computation High Low Method Step-2 Determine the fixed cost portion Take the total monthly cost at either the high point or the low point, and deduct the variable administrative cost from that amount. Let’s use the highest level of activity i.e. for April expense. Fixed Cost = Total Cost − Total Variable Cost = $25,280 − ($2.40 per unit × 950 units) = $25,280 − $2,280 = $23,000 per month Step-3 Determine a formula for estimating monthly administrative Cost; =$23,000 + $2.40 per unit. Remark ; This formula, in addition to helping the company evaluate the reasonableness of administrative costs incurred in a given month, it is also valuable in forecasting administrative costs likely to be incurred in the future.

45. 7.3 ASSUMPTIONS UNDERLYING COST-VOLUME-PROFIT ANALYSIS Throughout the presentation we have relied on certain assumptions that have simplified the application of cost-volume-profit analysis. These assumptions include: Sales price per unit is assumed to remain constant. If more than one product is sold, the proportion of products sold (the sales mix) is assumed to remain constant. Fixed costs (expenses) are assumed to remain constant at all levels of sales.

46. Continued…..ASSUMPTIONS Variable costs (expenses) are assumed to remain constant as a percentage of sales revenue. The number of units produced is assumed to equal the number of units sold of each period. Hence, as changes take place in selling prices, sales mix, expenses, and production levels, management should update and revise its analysis.

47. 8) Limitation of CVP Analysis Cost-volume-profit analysis is invaluable in demonstrating the effect on an organisation that changes in volume (in particular), costs and selling prices, have on profit. However, its use is limited because; It assumes either a single product is being sold or, if there are multiple products, these are sold in a constant mix. All other variables, apart from volume, remain constant – i.e. volume is the only factor that causes revenues and costs to change. In reality, this assumption may not hold true as, for example, if there is a change in sales mix, revenues will change. Furthermore, it is often found that if sales volumes are to increase, sales price must fall. The total cost and total revenue functions are linear and that is only likely to hold in a short-run, restricted level of activity. Profits are calculated on a variable cost basis

48. 9 ) Summary of ratios and mathematical relationships in CVP analysis Measurement Method of Computation -Contribution Margin Sales Revenue – Total Variable Costs -Unit Contribution Margin Unit Sales Price – Variable Costs per Unit -Contribution Margin Ratio Unit Sales Price – Variable Costs per Unit Unit Sales Price or Sales – Total Variable Costs Sales -BEP Sales Volume (in units) Fixed Costs + Target Operating Income Unit Contribution Margin -BEP Sales Volume (in dollars) Fixed Costs + Target Operating Income Contribution Margin Ratio -Margin of Safety Actual Sales Volume – Break-Even Sales Volume -Operating Income Margin of Safety × Contribution Margin Ratio -Change in Operating Income Change in Sales Volume × Contribution Margin Ratio

49. 10) References Williams, J.R.; Haka, S.F.; Bettner , M.S. and Carcello , J.V (2018). Financial and managerial accounting, 18 edition. https://www.accaglobal.com/gb/en/student/exam-support-resources/fundamentals-exams-study-resources/f5/technical-articles/CVP-analysis.html https://www.futurelearn.com/info/courses/financial-analysis-business-performance-reporting-stakeholder-management/0/steps/176858 https://xplaind.com/552306/cost-behavior https://saylordotorg.github.io/text_managerial-accounting/s10-02-cost-volume-profit-analysis-fo.html

50. END OF PRESENTATION