MGMT 9034 SU25 Cost-volume-profit Analysis

CVP Analysis

1. COST-VOLUME-PROFIT (CVP) ANALYSIS What is CVP ANALYSIS? CVP ASSUMPTIONS CVP Profit relationships Contribution margin income statement Break-Even and profit Analysis Margin of safety Degree of operating leverage

2. COST-VOLUME-PROFIT (CVP) ANALYSIS

3. Fixed Costs Total fixed costs do not change as volume changes. Unit fixed costs decreases as volume increases.

4. Variable Costs Total variable costs change in proportion to volume changes. Unit variable costs stay the same as volume changes.

5. Mixed Costs Mixed costs include both fixed and variable cost components. Mixed costs is greater than zero when volume is zero (fixed component) and increases steadily in proportion to increases in volume (variable component.

6. COST-VOLUME-PROFIT (CVP) ANALYSIS CVP analysis examines the interaction of a firm’s sales volume, selling price, cost structure, and profitability. It is a powerful tool in making managerial decisions including marketing, production, investment, and financing decisions. How many units of its products must a firm sell to break even? How many units of its products must a firm sell to earn a certain amount of profit?

7. CVP Model - Assumptions Key assumptions of CVP model CVP relationships are linear over a wide range of production and sales All costs can be classified as either fixed or variable Only volume affects total cost and total revenue Production volume is equal to sales volume Constant product mix

8. Graphing Cost-Volume-Profit Relationships Viewing CVP relationships in a graph gives managers a perspective that can be obtained in no other way.

9. Cost-Volume-Profit Graph Fixed cost line Total cost line Total Revenue line Break-even point Profit area Loss area

10. Cost-Volume-Profit Analysis Use CVP Analysis to find the BEP Contribution Margin Income statement Break-Even Sales xxx Less Variable costs xx =Contribution Margin xx Less Fixed costs xx Operating Income xxx Break-even in units = Total Fixed costs Contribution margin per unit Sales to BE = Fixed Cost / Contribution Margin Target sales = Fixed costs + Target operating income Contribution margin

11. Cost-Volume-Profit Analysis City Travel Agency specializes in flights between Boston and Mexico City. It books passengers on Delta airlines. City Travel’s fixed costs are $22,000 per month. Delta Air charges passengers $1,000 per round-trip ticket. Calculate the number of tickets City Travel must sell each month to (a) Break even and (b) make a target operating income of $10,000 per month in each of the following independent cases. 1) City Travel’s variable costs are $35 per ticket. Delta Air pays City Travel 8% commission on ticket price 2) City Travel’s variable costs are $29 per ticket. Delta Air pays City Travel 8% commission on ticket price 3)City Travel’s variable costs are $29 per ticket. Delta Air pays $48 fixed commission per ticket to City Travel 4)City Travel’s variable costs are $29 per ticket. It receives $48 commission per ticket from Delta Air. It charges its customers a delivery fee of $5 per ticket.

12. Cost-Volume-Profit Analysis City Travel Agency specializes in flights between Boston and Mexico City. It books passengers on Delta airlines. City Travel’s fixed costs are $22,000 per month. Delta Air charges passengers $1,000 per round-trip ticket. Calculate the number of tickets City Travel must sell each month to (a) Break even and (b) make a target operating income of $10,000 per month in each of the following independent cases. 1) City Travel’s variable costs are $35 per ticket. Delta Air pays City Travel 8% commission on ticket price Sales 1000 * 8% = $80 Number of tickets to BE = $22,000/$45 =489 Tickets Less VC 35 Contribution Margin 45 to make $10,000 = $22,000 +$10,000 =712 tickets $45 2) City Travel’s variable costs are $29 per ticket. Delta Air pays City Travel 8% commission on ticket price Sales 1000 * 8% = $80 Number of tickets to BE = $22,000/$51 =432 Tickets Less VC 29 Contribution Margin 51 $22,000+ $10,000 =628 tickets to achieve $10,000 target income $51

13. Cost-Volume-Profit Analysis City Travel Agency specializes in flights between Boston and Mexico City. It books passengers on Delta airlines. City Travel’s fixed costs are $22,000 per month. Delta Air charges passengers $1,000 per round-trip ticket. Calculate the number of tickets City Travel must sell each month to (a) Break even and (b) make a target operating income of $10,000 per month in each of the following independent cases. 3)City Travel’s variable costs are $29 per ticket. Delta Air pays $48 fixed commission per ticket to City Travel Sales = $48 Number of tickets to BE = $22,000/$19 =1158 Less VC 29 Contribution Margin 19 $22,000+ $10,000 =1685 tickets to make $10,000 target income $19 4)City Travel’s variable costs are $29 per ticket. It receives $48 commission per ticket from Delta Air. It charges its customers a delivery fee of $5 per ticket. Sales = $53 Number of tickets to BE = $22,000/$24 =917 Less VC 29 Contribution Margin 24 $22,000+ $10,000 =1334 tickets to make $10,000 target income $24

14. Cost-Volume-Profit Analysis Additional Example: Suppose that Super Bikes wants to produce a new mountain bike called HR1 and has forecast the following information. Price per bike = $800 Variable cost per bike = $300 Fixed costs related to bike production = $55,000 Target Profit = $20,000 Estimated sales = 12, 000 bikes

15. Cost-Volume-Profit Analysis We determine the quantity of bikes needed for the target profit as follows: (55,000 + 20,000)/(800-300) = 150 bikes Break-even units = 55000/(800-300) = 110 Total revenue = 800*12,000 = 9,600,000 Total variable cost = 300*12,000 = 3,600,000 Total Contribution margin = 9,600,000-3,600,000/9,600,000 = 0.625 Total operating income = 9,600,000-3,600,000-55,000= 9600000-3600000-55000 = 5945000

16. Margin of Safety The difference between actual or budgeted sales and the break-even point. In break-even analysis, the term margin of safety indicates the amount of sales that are above the break-even point. In other words, the margin of safety indicates the amount by which a company's sales could decrease before the company will have no profit. Example of Margin of Safety Let's assume that a company currently sells 3,000 units of its only product. The company has estimated that its break-even point is 2,800 units. Therefore, the company's margin of safety is 200 units. Formula: Actual or budgeted sales – break-even sales = Margin of safety The margin of safety can be shown two ways: (1) as the difference between the current level of sales (when sales exceed break-even) and the break-even point, (3000-2800=200) or (2) as a percent of the current level of sales (3000-2800/3000=6.7%)

17. Weighted-Average Contribution Margin The Weighted-average contribution margin is the average unit contribution margin of multiple products weighted according to the percentage of units sold Coffee and pantries Assume 60% of units sold are coffee and 40% are pantries Coffee Pantries Sales price $2.50 $4.00 Less: Variable cost 1.00 1.25 Unit contribution margin $1.50 $2.75 Coffee Pantries Unit contribution margin $1.50 $2.75 Unit mix (weight) x60% X40% $.90 $1.10 Weighted-average unit contribution margin $.90+$1.10=$2.00

18. Weighted-Average Contribution Margin Assume Fixed costs are $12,000, Break-Even point would be calculated as follows: Total Fixed Costs = Break-Even Units Weighted-Average Unit Contribution Margin $12,000 = 6,000 Units $2 This shows that 6,000 total units are required to break even. But how many of these units should be coffee and how many pastries? Coffee Units = 6,000 x 60% = 3,600 Pastry Units = 6,000 x 40% = 2,400

19. Degree of Operating Leverage In physics, a lever is a tool that allows a small amount of force to move a heavy object. In business, managers can use fixed costs as a lever to turn relatively small changes in sales revenue into large changes in profit. Decisions about whether to use fixed or variable costs to run the business affect a company’s operating leverage. Degree of operating leverage = Contribution Margin Net Operating Income DOL FOR ABC = 135,000/5000 = 27, DOL for XYZ = 120,000/40,000 = 3 10% increase in sales, income = 270%, 3*10% = 30% When a firm is closer to break-even point and there is an increase in sales, there will a bigger effect on the net operating income number. DOL is not constant ABC COMPANY ZYZ COMPANY Sales 200,000 200,000 Variable Costs 65,000 80,000 Contribution Margin 135,000 120,000 Fixed Costs 130,000 80,000 Net Operating Income 5,000 40,000