PPT Ch18 Management Accounting 5e

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Chapter 18

Cost volume profit analysis

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Copyright 2009 McGraw-Hill Australia Pty Ltd

PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith

Prepared by Kim Langfield-Smith

Outline

• What is CVP analysis?

• The break-even point

• Graphing CVP relationships

• Target net profit

• Using CVP analysis for management decisions

• CVP analysis with multiple products

• Including income taxes in CVP analysis

• Practical issues in CVP analysis

• An activity-based approach to CVP analysis

• Financial planning models

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Cost volume profit (CVP) analysis

• A technique used to determine the effects of

changes in an organisation’s sales volume on its

costs, revenue and profit

• Can be used in profit-seeking organisations and

not-for-profit organisations

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The break-even point

• The volume of sales where the total revenues and

costs are equal, and the operation breaks even

• At this level of sales, there is no profit or loss

• Can be calculated for an entire organisation or for

individual projects

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Break-even formulas

ratiomargin on contributiUnit

costs Fixed =dollar) sales(in point even -Break

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margin oncontributi Unit

costs Fixed =units) (in point even-Break




Terminology

• Contribution margin (or variable costing)

statement

– An income statement that separates fixed and variable

costs and calculates a contribution margin

• Total contribution margin

– The difference between the total sales revenue and the

total variable costs

– The amount available to cover fixed costs and then

contribute to profits

• Unit contribution margin

– The difference between the sales price per unit and the

variable cost per unit

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(cont.)




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Terminology (cont.)

• Contribution margin ratio

– The unit contribution margin divided by the unit sales

price

– The proportion of each sales dollar available to cover

fixed costs and earn a profit

• Contribution margin percentage

– The contribution margin ratio multiplied by 100

– The percentage of each sales dollar available to cover

fixed costs and earn a profit

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Graphing cost volume profit

relationships

• Shows how costs, revenue and profits change as

sales volume changes

• Five steps

1. Draw the axes of the graph

2. Draw the fixed cost line

3. Draw the total cost line

4. Draw the total revenue line

5. Break-even point—where the total revenue and total

cost lines intersect

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Profit volume (PV) graph

• Shows the total amount of profit or loss at different

sales volumes

• The graph intercepts the vertical axis at the

amount equal to the fixed costs

• The break-even point is the point at which the total

profit/loss line crosses the horizontal axis

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Target net profit

• A desired profit level determined by management

• The break-even formula can be sued to determine

the target profit

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margin oncontributi Unit

profit target + costs Fixed =volume sales Target




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Using CVP analysis for

management decision making

• Safety margin

– Difference between the budgeted sales revenue and

break-even sales revenue

– Gives a feel for how close projected operations are to the

break-even point

• Changes in fixed costs

– Percentage change in fixed costs will lead to a similar

increase in the break-even point (in units or dollars)

– Different fixed costs may apply to different levels of

sales/production volume, and provide more than one

break-even point

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(cont.)

Using CVP analysis for

management decision making

(cont.)

• Changes in the unit contribution margin

– Change in unit variable costs, leads to new

– unit contribution margin and new break-even point

– An increase in unit variable costs will increase the break-

even point

– An increase in unit price will lower the break-even point

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Multiple changes in key variables

• May involve, for example

– Increasing unit prices

– Increasing selling prices

– Undertaking a new advertising campaign

– Leasing a new office

• An incremental approach to analysis

– Focuses on the differences in the total contribution

margin, fixed costs and profits under the two alternatives

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CVP analysis with multiple

products

• Sales mix

– The relative proportions of each type of product sold by

the organisation

• Weighted average unit contribution margin

– The average of the products’ unit contribution margins,

weighted by the sales mix

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margin oncontributi unit average Weighted

costs Fixed=point even-Break




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Including income taxes in CVP

analysis

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margin oncontributi unit

)-(1

tax after profit net target + costs Fixed

=

profittax -after target earn to required volume Sales

t




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Assumptions underlying CVP

analysis

• The behaviour of total revenue is linear

• The behaviour of total costs is linear over a

relevant range

– Costs can be categorised as fixed, variable or

semivariable

– Labour productivity, production technology and market

conditions do not change

– There are no capacity changes during the period under

consideration

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(cont.)

Assumptions underlying CVP

analysis (cont.)

• For both variable and fixed costs, sales volume is

the only cost driver

• The sales mix remains constant over the relevant

range

• In manufacturing firms, the levels of inventory at

the beginning and end of the period are the same

– Thus, the number of units produced and sold during a

period are equal

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CVP analysis and longer-term

decisions

• CVP analysis is usually regarded as a short-term

or tactical decision tool

• Classification of costs as variable or fixed is

usually based on cost behaviour over the short

term

• The financial impact of long-term decisions is best

analysed using capital budgeting techniques

– Takes into account the time value of money

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Treating CVP analysis with

caution

• CVP analysis is merely a simplified model

• The usefulness of CVP analysis may be greater in

less complex smaller firms, or stand-alone

projects

• For larger firms, CVP analysis can be valuable as

a decision tool for the planning stages of new

projects and ventures

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An activity-based approach to CVP

analysis

• ABC categorises activities as unit, batch, product

or facility level

– Facility, product and batch activities are non-volume

activity costs

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unit per costs-unit per price Selling

costs levelfacility and product batch, Total=point even-Break




Limiting assumptions of CVP

analysis using activity-based

costs

• Total batch level costs are dependent on the

batch size and the break-even/target production

level

• Management may change the batch size at

certain production volume levels and this will

change the break-even volume

• More complex models are needed where there

are multiple products

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Financial planning models

• Sensitivity analysis and CVP analysis

– An approach that examines how an outcome may change if

there are variations in the predicted data or underlying

assumptions

• Can be run using spreadsheet software, such as Excel

• Goal seek approaches

– The analyst specifies the outcome, and the software specifies

the necessary inputs

• What-if analysis

– The analyst specifies changes in assumptions and data to

examine the effect of these changes on the outputs

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Summary• CVP analysis is a decision tool that can be used to

assess the effects on changes in profit of changes in

sales volume, sales price, sales mix and costs

• The break-even point is the sales level at which sales

covers costs—there are zero profits

• The break-even formula can be modified to calculate

target profit, and to include sales mix and income

taxes

• CVP analysis has several assumptions which limit its

usefulness for decision making

• Activity-based approaches and financial planning

modelling can provide more sophisticated models

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PPT Ch18 Management Accounting 5e

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