Chapter 7: Cost-Volume-Profit (Part 1 of 3)

Sections 1 and 2Feb 4, 2013

Professor: Khim KellyOffice: HH386B

Office Hours: Mon/Wed 11:30am – 12:30pm and AppointmentEmail: kokelly@uwaterloo.ca

TA: Kun HuoEmail: khuo@uwaterloo.ca

Ch. 7 Assignment due Feb 11(Mon), 11.59pm

Kun will be teaching Ch. 7

BE NICE TO HIM : )

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4 Feb 2013 Overview

• Last lecture– Completed Chapter 6 (Cost Behavior)

• Today’s lecture …– Basics of Chapter 7– CM Ratio– Break even Analysis

Cost-Volume-Profit• Uses …– Breakeven analysis– Scenario analysis (i.e. change in inputs)– Cost structure planning and leverage– Indifference calculations

• CVP considers how income is affected by:– Prices of products (i.e. sales price)– Variable costs per unit– Total fixed cost– Volume or level of activity (‘X’)– Mix of products sold

Contribution Margin

• CM is used to cover fixed costs, THEN anything left is profit

• Profit = Sales – Variable Costs – Fixed Costs

CM

Contribution Margin• Sales price per unit: $100• Variable cost per unit: $50• Fixed costs: $500,000• What would the operating income (loss) be if:

– 0 units produced?Operating loss = CM – FC = Sales – VC – FC =$0 – $0 - $500,000 = ($500,000)– 1 unit produced?Operating loss = CM – FC = Sales – VC – FC =$100 – $50 - $500,000 = ($499,950)– 10,000 units produced?Operating loss = ????

Break-even Point

• Break-even point is …– The level of sales at which profit = 0– Also known as the point where total sales = total

expenses or where total contribution margin = fixed expenses

Break-even point:Profit = Sales – Variable Costs – Fixed Costs = $0

CM – Fixed Cost = $0

Total Expenses …

Activity

$

Fixed Expenses

Variable Expenses

Total Expenses

CVP Relationships in Graphical Form

Activity

$

Total Expenses

Total Sales Revenue

As long as Contribution Margin > 0

CVP Relationships in Graphical Form

Activity

$

Total Expenses

Total Sales Revenue

Profit Area

Loss Area

Break-even Point

Contribution Margin Ratio

• CM ratio …– Contribution margin (Sales less Variable Expenses) as a

percentage of total sales (say 40%)– For every $1 of sales increase, CM will increase by $0.40– The effect on operating income of any dollar change in total

sales can be computed by applying the CM ratio to the dollar change

CM Ratio = Total CM per unitTotal Sales per unit

Total CMTotal Sales

=

Change in op income = Change in sales x CM Ratio

It is Clicker Time!!

Feel Free to Work Together on Clicker Questions

Clicker Question #1Q: Dillon’s (Khim’s son) garage band – Tone Death

– sold out 40 concerts in Khim’s basement, had total revenue of $3000, variable expenses of $2400, and total fixed expenses of $450. What is the band’s contribution margin ratio?

A. 25%B. $600C. 20%D. $150E. Ozzy Osbourne

Clicker Question #2Q: Dillon’s garage band – Tone Death – sold out 40

concerts, had total revenue of $3,000, variable expenses of $2,400, and total fixed expenses of $450. Estimate the change in the band’s income if total sales increased by $1,500 to a total of $4,500 (i.e., Khim forced all her AFM102 students to buy tickets)?

A. ($150)B. $300C. ($5,012.62)D. $150E. $450

Clicker Question #3

Q: Acoustic is selling 400 speakers per month @ $250 per speaker for total monthly sales of $100,000. Current variable costs are $60,000 and current fixed costs are $35,000. Financially speaking, should they increase sales by $30,000 by increasing fixed costs (advertising) by $10,000?

A. YesB. No

Example: Application of CVP

Solution 1: CM Ratio [(100k – 60k)/100k] 40% Expected CM with new advertising $52K (130K*40%)

Current CM (100K*40%) $40KIncremental CM $12K

Change in Fixed Costs ($10K) Change in Operating Income $2K

Example: Application of CVPSolution 2 (incremental approach):

Incremental CM (30K*40%) $12K Change in Fixed Costs ($10K) Change in Operating Income $2K

• Incremental analysis focuses only on the items that will change as a result of a decision.

• In general, if a change result in Increase in CM > Increase in fixed costs [or Decrease in CM < Decrease in fixed costs], then the change should be made

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Change VC + Target Profit (P7-27)You manufacture skateboards that sell for $37.50. Rely on direct labour workers and variable costs are $22.50 per board. In the last year you sold 40,000 boards:Q. Increase of $3 in labour per board expected. How many

boards do you need to make to earn the same Op. Income?

Income Statement

Sales 1,500,000VC 900,000 CM $600,000 FC 480,000 Op. Income $120,000

Before:Old Unit CM = $37.50 – $22.50 = $15 $15*40,000 - $480,000 = $120,000

Now (Increase in VC):

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Change VC + Target Profit (P7-27)

Alternatively:FC is not a differential cost (see pg. 47). Therefore, the simplest way is to make the CM of both options equal.

Income Statement

Sales 1,500,000VC 900,000 CM $600,000 FC 480,000 Op. Income $120,000

Before:Old CM = $15*40,000

Now (Increase in VC):New CM = $12*X

CM equivalence:

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Change VC + CM Ratio (P7-27)You manufacture skateboards that sell for $37.50. Rely on direct labour workers and variable costs are $22.50 per board. In the last year you sold 40,000 boards:Q. Increase of $3 in labour per board expected. What is the sales

price for the same CM Ratio?

Income Statement

Sales 1,500,000VC 900,000 CM $600,000 FC 480,000 Op. Inc. $120,000

Before:CM Ratio = $600,000/$1,500,000 = 40%

Now (Increase in VC):

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Shift to FC from VC (P7-27)You manufacture skateboards that sell for $37.50. Rely on direct labour workers and variable costs are $22.50 per board. In the last year you sold 40,000 boards:Q. Should you automate your manufacturing? This results in VC to

decrease 40% and FC to increase 90%. How many units (X) do we need to earn the same Op. Income?

Income Statement

Sales 1,500,000VC 900,000 CM $600,000 FC 480,000 Op. Inc. $120,000

Income Statement

Sales $37.50XVC ($22.5*0.6)XCM $24.00X FC $480,000 * 1.9Op. Inc. $120,000

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Shift to FC from VC (P7-27)Op. Inc = CM – FC

Income Statement

Sales 1,500,000VC 900,000 CM $600,000 FC 480,000 Op. Inc. $120,000

Income Statement

Sales $37.50XVC $13.50XCM $24.00X FC $912,000Op. Inc. $120,000

Important points

• Use the formula flexibly– Income = Sales – VC – FC– Income = Units sold * price – units sold * VC per unit –

FC– Income = Units sold * (price – VC per unit) – FC

• We test you by changing any of the variables but the concept remains the same!

• Make sure you identify the variable of interest first• Buy Dillion’s concert tickets, circa 2025, spaces are

limited!

Summary

• Today’s lecture …– Basics of CVP– Contribution Margin ratio– Break even analysis

• Next lecture …– More break even analysis– Margin of safety analysis– Target operating profit analysis