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Cost-Volume-ProfitAnalysis

TransitionNotes

Thischaptercontainsupdatedcoverageofstrategyandstrategicusesofcostinformation.Thefive-stepdecisionprocessisappliedtoCost-Volume-Profit(CVP)decisions.Thereisashifttothe“essentials”ofcost-volume-profitanalysiswithlessfocusontheassumptionsofCVPanalysis.Thisisinlinewiththeincreasedfocusonthemanagerialaspectsofthetext.Discussionofalternativefixed/variablecoststructures,multipleproductbreakevenanalysis,andcontributionmarginversusgrossincomehavebeenrevisedandshortened.Thereareseveralsignificantrevisionsandadditionstotheproblemmaterialattheendofthechapter.

EXERCISESANDPROBLEMS

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I. LEARNINGOBJECTIVES

Explainthefeaturesofcost-volume-profit(CVP)analysis.

Determinethebreakevenpointandoutputlevelneededtoachieveatargetoperatingincome.

UnderstandhowincometaxesaffectCVPanalysis.

ExplainhowmanagersuseCVPanalysistomakedecisions.

Explainhowsensitivityanalysishelpsmanagerscopewithuncertainty.

UseCVPanalysistoplanvariableandfixedcosts.

ApplyCVPanalysistoacompanyproducingmultipleproducts.

ApplyCVPanalysisinserviceandnot-for-profitorganizations.

Distinguishcontributionmarginfromgrossmargin.

CHAPTERSYNOPSIS

Thischapterpresentsthecost-volume-profit(CVP)analysismodelandillustrateshowmanagersusethatmodeltohelpanswerimportant“what-if”businessquestions.CVPanalysisalsohelpsmanagementaccountantsalertmanagerstotherisksandrewardsofdecisionstheyareconsideringbyillustratinghowthe“bottom-line”isaffectedbychangesinactivitylevelsorkeypricingorcostcomponents.CVPanalysisisbasedonseveralassumptions,oneofwhichisthatfixedcostscanbedistinguishedfromvariablecosts.However,whetheracostisvariableorfixeddependsonthetimeperiodforthedecisionandalsotherangeofactivity(relevantrange)beingconsidered.StudentsarealsopresentedwithamethodforapplyingCVPanalysistocompanieswithmultipleproductsandtosituationswherethereismorethanonecostdriver.TheapplicabilityofCVPtomanufacturers,serviceorganizations,andnonprofitsisdiscussed.Contributionmarginisalsodefinedanddistinguishedfromgrossmargin.

III. PointsofEmphasis

Theconceptsofcontributionmargin,contributionmarginincomestatement,breakeven,targetoperatingincome,alongwithothermeasuresareintroducedinthischapter.Thisisa“nutsandbolts”chapterthatthestudentshouldunderstandiftheyaretograspthematerialcoveredinfuturechapters.Spendtimehavingthestudentsworkthroughproblemsthatcovertheconceptsfromthischapter.

Sensitivityanalysisisavaluabletoolthatstudentscanusetodeterminetheexpectedoutcomefromvariousscenarios.

Operatingleverageisaconceptthatwillhelpthestudentsunderstandwhyoperatingincomechangesasitdoes.HelpthestudentsseetheusefulnessofDOL(DegreeofOperatingLeverage).

IV. CHAPTEROUTLINE

LEARNING

OBJECTIVE

1

Explainthefeaturesofcost-volume-profit(CVP)analysis

…howoperatingincomechangeswithchangesinoutputlevel,sellingprices,variablecosts,orfixedcosts

Cost-volume-profit(CVP)analysisstudiesthebehavioroftotalrevenues,totalcosts,andoperatingincomeaschangesoccurintheunitssold,thesellingprice,thevariablecostperunit,orthefixedcostsofaproduct.

Thefive-stepdecision-makingprocessoutlinedinChapter1canbeutilizedindoingCVPanalysis.Toreview,thefivestepsare:

Identifytheproblemsanduncertainties.

Obtaininformation.

Makepredictionsaboutthefuture.

Makedecisionsbychoosingamongalternatives.

Implementthedecision,evaluateperformance,andlearn.

(TheEmmaJonesexampleinthetextdetailseachofthesestepsasfacedbyaGMATtestpreparationsalesperson.)

1.3 Contributionmarginisthedifferencebetweentotalrevenuesandtotalvariablecosts.Thisisanindicationofwhyoperatingincomechangesasthenumberofunitssoldchanges.

1.4 Contributionmarginperunitisthedifferencebetweensellingpriceandvariablecostperunit;thatis,contributionmarginperunitisthechangeinoperatingincomeforeachadditionalunitsold.

1.5 Acontributionincomestatementisanincomestatementthatgroupscostsintotheirvariableandfixedcomponents.Variablecostsaresubtractedfromrevenuestohighlightcontributionmargin.Fixedcostsaresubtractedfromcontributionmargintoarriveatoperatingincome.

(Exhibit3-1illustratesacontributionmarginincomestatement.)

Teachingpoint.Thisisagoodtimetoreinforcethedefinitionsoffixedandvariablecostsandtheirbehaviorintotalandperunit.Timespentherewillhelpstudentsgraspthedifferencesinhowthesecostsbehave.

1.6 Thecontributionmarginpercentageorratioequalscontributionmarginperunitdividedbythesellingprice.Thisisanindicationofthepercentofeachsalesdollarthatisavailabletopayfixedcostsandreturnaprofit.

1.7 CVPrelationshipsandthecalculationofoperatingincomecanbeillustratedusingthreemethods:

Equationmethod.Theequationmethodisbasedonthefollowingformula:

(Sellingprice×Quantityofunitssold)–(Variablecostperunit×Quantityofunitssold)–Fixedcosts=Operatingincome

Contributionmarginmethod.Underthisapproachtheequationisrearrangedtocalculatecontributionmarginperunit.Thisexpressesthebasicideathateachunitsoldcontributesthatamountperunittofixedcostsorprofit.

[(SellingPrice–Variablecostperunit)xQuantityofunitssold]–FixedCosts=Operatingincome

(SellingPrice–Variablecostperunit)=Contributionmarginperunit

Graphmethod.Thegraphmethodrepresentstotalcostsandtotalrevenuesgraphically.Whencostsandrevenuesarenettedandgraphedasoneline,thisisoftenreferredtoasaprofit-volumeorPVgraph.

(Exhibits3-2and3-3illustratethegraphmethodwithacost-volume-profitgraphandaprofit-volumegraph.)Gooverthese,anddiscusseachlineonthegraphanditssignificance.

1.8 Cost-Volume-ProfitAssumptions.ThereareanumberofassumptionsthatmustbemadeinconductingCVPanalysis.Althoughtheseassumptionsdonotalwayspreciselyhold,theycanallowmeaningfulanalysis.

Changesinthelevelsofrevenuesandcostsariseonlybecauseofchangesinthenumberofunitssold.Thus,numberofunitssoldistheonlyrevenueandcostdriver.

Totalcostscanbeseparatedintofixedandvariablecomponents.

Teachingpoint.Emphasizetothestudentsthatthisisusuallypossible;thequestionis:“Dotheyhavetheabilitytomakethisdivision,giventhedataavailableandtheirlevelofskill?”

Totalrevenuesandtotalcostsarelinear;thatis,whengraphedtheycanberepresentedasastraightline.

Sellingprice,variablecostperunit,andtotalfixedcosts(withinarelevantrange)areknownandconstant.

Teachingpoint.Obviously,theseassumptionsdonotholdovertime.Pointoutthatanytimeoneofthefactorschanges,itchangesthedynamicsandtheanalysismustberepeated.

RefertoQuizQuestion1

LEARNING

OBJECTIVE

2

Determinethebreakevenpointandoutputlevelneededtoachieveatargetoperatingincome

…comparecontributionmarginandfixedcosts

2.1 BreakevenPoint(BEP).Thebreakevenpointisthatquantityofoutputsoldatwhichtotalrevenuesequaltotalcosts.FollowingistheformulaforcalculatingBEPinunits:

Fixedcosts

Unitcontributionmargin

2.2 However,BEP,andthereforezeroprofit,isnotwhatcompaniesshouldstrivefor.Managersareconcernedwithhowtheycanachievetheirgoalsforoperatingprofit.Targetoperatingincomeisthelevelofsalesneededtoattainaspecifieddollaramountofoperatingincome.InordertodetermineTOI,addthedesiredoperatingincometofixedcostinthebreakevencalculation.

Teachingpoint.Workwiththeclassindoingvariousexercisesthatillustratethepointscoveredinthislearningobjective.Contributionmargin,CMratio,andbreakevenpointareunderstoodmuchmorereadilywhenstudentsseehowthesearecalculated,ratherthansimplylearningadefinitionofthem.Exercises3-24and3-25illustratetheseconcepts.

(Exhibits3-2and3-3graphicallyillustratetheCVPanalysisofbreakevenpoint.)

(Exhibit3-4displaystheunderlyingspreadsheetdata.)

RefertoQuizQuestions2and3 Exercises3-24and3-25

LEARNING

OBJECTIVE

3

UnderstandhowincometaxesaffectCVPanalysis

…focusonnetincome

3.1 Netincomeisoperatingincomeplusnonoperatingrevenues(suchasinterestrevenues)minusnonoperatingexpenses(suchasinterestexpense)minusincometaxes.

3.2 Tothispoint,wehaveignoredtheeffectofincometaxesinourCVPanalysis.Tomakenetincomeevaluations,however,wemuststateresultsintermsoftargetnetincomeratherthantargetoperatingincome.

3.3 TheTOIcalculationcanbeeasilyadjustedtoaccommodatethischange:

TargetNI=TOI–(TOITaxrate)orstatedanotherway

TargetNI=TOI(1–Taxrate)

RefertoQuizQuestions4-6 Exercise3-26

LEARNING

OBJECTIVE

4

ExplainhowmanagersuseCVPanalysisindecisionmaking

…choosethealternativethatmaximizesoperatingincome

4.1 CVPanalysisisusefulinnumeroussituationstoevaluateanticipatedresultsfromstrategicdecisions.DecisionssuchaswhethertoincreaseadvertisingorreducethesellingpricecanbefacilitatedwithCVPanalysis.Thesetypesofproblemsareillustratedinthetext.

RefertoQuizQuestions7and8 Exercise3-28

LEARNING

OBJECTIVE

5

Explainhowsensitivityanalysishelpsmanagerscopewithuncertainty

…determinetheeffectonoperatingincomeofdifferentassumptions

5.1 Sensitivityanalysisisatechniquethatmanagersusetoexaminetheeffectofchangesinthevariablesthatwillaffecttheoutcomeofthedecision.Thisisalsoreferredtoas“whatif”analysis;thatis,asking:“Whatwouldhappenif…?”

Teachingpoint.SensitivityanalysisisanexcellenttooltoillustratethepracticalusefulnessofExcel.ByprogrammingthedecisiondataintoanExcelspreadsheet,theeffectofchangesinvariablescanbeinstantlyseenbychangingthevalueonthespreadsheet.

5.2 Themarginofsafetyisanotheraspectofsensitivityanalysis.Itmaybeexpressedinunits,dollars,orasapercentage.Itisdefinedastheamountbywhichthecurrentlevelofsalesexceedsthebreakevenpoint;thatis,itisameasureofhowmuchsalescandeclineandhavethecompanyremainprofitable.

Marginofsafetyindollars=Revenues–Breakevenrevenues

Marginofsafetyunits=Salesinunits–Breakevenunits

Marginofsafetypercentage=Marginofsafetyindollars/Revenues

5.3 Sensitivityanalysisrecognizesuncertainty,thepossibilitythatactualamountsofrevenueandcostswilldifferfromexpectedamounts.

Problem3-29

LEARNING

OBJECTIVE

6

UseCVPanalysistoplanvariableandfixedcosts

…compareriskoflossesversushigherreturns

6.1 Managershavetheabilitytochoosethelevelsoffixedandvariablecostsintheircoststructures.Thisisastrategicdecisionandcanbeassimpleaschoosingbetweenautomationandalabor-basedmanufacturingoperation.

6.2 Sensitivityanalysiscanbeutilizedinmakingthedecisiontosubstitutefixedcostsforvariablecostsinthecoststructure.Exhibit3-4illustratestheeffectsofachoiceoffixedovervariableinthecoststructure.

6.3 Operatingleveragedescribestheeffectsoffixedcostsonchangesinoperatingincomewithchangesincontributionmarginorvolume.Itisdefinedasthepercentagechangeinoperatingincomefromagivenchangeinsalesandisdescribedasdegreeofoperatingleverage(DOL).Forexample,acompanythathasaDOLof4willexperienceachangeinoperatingincomefourtimesthechangeinrevenues.Ifrevenuesincrease5%,operatingincomewouldincrease4×5or20%.

6.4 DOLiscalculatedasfollows:

Teachingpoint.NotethatDOLisatwo-edgedsword,withanincreaseinrevenues.AhighDOLacceleratestheincreaseinoperatingincome.However,adecreaseinrevenuesacceleratesthedecreaseinoperatingincome.DOLalsochangesasrevenueschange;itsvalueisdependentonthelevelofsales.

RefertoQuizQuestions9and10 Problem3-48

LEARNING

OBJECTIVE

7

ApplyCVPanalysistoacompanyproducingmultipleproducts

…assumesalesmixofproductsremainsconstantastotalunitssoldchanges

7.1 Salesmixisthequantitiesorproportionsofvariousproductsorservicesthatconstitutethetotalsalesofacompany.TheCVPanalysisdiscussedtothispointassumesasingleproduct.Thisisnotreasonable,asmostcompaniessellalargevarietyofproducts.

7.2 RecallthatoneoftheassumptionsofCVPanalysiswasthat“sellingprice,variablecostperunit,andtotalfixedcostsareknownandconstant.”Withproductshavingdifferentsellingpricesandvariablecosts,howcanthesaleofmultipleproductsbeadaptedtofittheCVPmodel?

7.3 CVPanalysiswithmultipleproductsisperformedbycalculatingaweightedaveragecontributionmarginbaseduponaconstantsalesmixpercentage.ThisisillustratedinthetextandinExercise3-33andProblem3-51.

RefertoQuizQuestions11 Exercise3-33;Problem3-51

LEARNING

OBJECTIVE

8

ApplyCVPanalysisinserviceandnot-for-profitorganizations

…defineappropriateoutputmeasures

8.1 CVPanalysisforserviceandnot-for-profitorganizationsdiffersfromotherorganizations.CVPneedtofocusonmeasuringtheiroutputwhichisdifferentfromthetangibleunitssoldbymanufacturingandmerchandisingcompanies.

Someexamplesofoutputthatcanbemeasuredarepassengermilesforairlines,patientdaysforhospitalsandstudentcredit-hoursforuniversities.

LEARNING

OBJECTIVE

9

Distinguishcontributionmargin

…revenuesminusallvariablecosts

fromgrossmargin

…revenuesminuscostofgoodssold

9.1 Grossmarginmeasureshowmuchacompanycanchargeforitsproductsoverandabovethecostofacquiringorproducingitsproducts.Contributionmarginindicateshowmuchofacompany’srevenuesareavailabletocoverfixedcosts.

APPENDIX

A.1 Businessdecisionsaremadeinaworldofuncertainty.Adecisionmodelhelpsmanagersdealwithuncertaintythroughafive-stepprocess.

A.2 Steponeistoidentifyachoicecriterion—anobjectivethatcanbequantified.

A.3 Steptwoidentifiesthesetofalternativeactionsthatcanbetaken.

A.4 Instepthree,managersidentifythesetofeventsthatcanoccur.Aneventisapossiblerelevantoccurrence.Theseeventsshouldbemutuallyexclusive.

TeachingPoint.Rollingadieisaneventwithsixpossibleoutcomes,eachofwhichismutuallyexclusive.

A.5 Managersassignaprobabilitytoeacheventthatcanoccurinstepfour.Aprobabilitydistributiondescribesthelikelihoodthateachofthemutuallyexclusiveeventswilloccur.Theseprobabilitieswillequal1.0.

A.6 Stepfiveistoidentifythesetofpossibleoutcomes—thepredictedeconomicresultsofthepossiblecombinationsofactionsandevents.Theseoutcomesaresummarizedinadecisiontable.

A.7 Theexpectedvalueistheweightedaverageoftheoutcomeswiththeprobabilityofeach outcomeservingastheweight.Whenmeasuredinmonetaryterms,thisiscalledtheexpectedmonetaryvalue.

V. OTHERRESOURCES

Todownloadinstructorresources,visittheInstructor’sResourceCenterat/irc.

ThefollowingexhibitswerementionedinthischapteroftheInstructor’sManual,andhavebeenincludedintheImageLibrary.

Exhibit3-1illustratesacontributionmarginincomestatement.

Exhibits3-2and3-3illustratethegraphmethodwithacost-volume-profitgraphandaprofit-volumegraph.Gooverthese,anddiscusseachlineonthegraphanditssignificance.

Exhibit3-4displaysaspreadsheetdepictingaCVPsensitivityanalysisanditseffectonoperatingincome.

CHAPTER3QUIZ

Whichofthefollowingisnotafactorincost-volume-profitanalysis?

Unitssold

Sellingprice

Totalvariablecosts

Fixedcostsofaproduct

Whichofthefollowingisnotanassumptionofcost-volume-profitanalysis?

Thetimevalueofmoneyisincorporatedintheanalysis.

Costscanbeclassifiedintovariableandfixedcomponents.

Thebehaviorofrevenuesandexpensesisaccuratelyportrayedaslinearovertherelevantrange.

Thenumberofoutputunitsistheonlydriver.

Contributionmarginiscalculatedas

totalrevenue–totalfixedcosts.

totalrevenue–totalmanufacturingcosts(CGS).

totalrevenue–totalvariablecosts.

operatingincome+totalvariablecosts.

Questions4through6arebasedonthefollowingdata.

TeeTimes,Inc.producesandsellsthefinestqualitygolfclubsinallofClayCounty.Thecompanyexpectsthefollowingrevenuesandcostsin2020foritsEliteQualitygolfclubsets:

Revenues(400setssold@$600perset) $240,000

Variablecosts 160,000

Fixedcosts 50,000

HowmanysetsofclubsmustbesoldforTeeTimes,Inc.toreachtheirbreakevenpoint?

a. 400

b. 250

c. 200

d. 150

Howmanysetsofclubsmustbesoldtoearnatargetoperatingincomeof$90,000?

a. 700

b. 500

c. 400

d. 300

WhatamountofsalesmustTeeTimes,Inc.havetoearnatargetnetincomeof$63,000iftheyhaveataxrateof30%?

a. $489,000

b. $429,000

c. $420,000

d. $300,000

Onewayformanagerstocopewithuncertaintyinprofitplanningisto

useCVPanalysisbecauseitassumescertainty.

recommendmanagementhireafuturistwhoseworkistopredictbusinesstrends.

waittoseewhatdoeshappenandprepareareportbasedonactualamounts.

usesensitivityanalysistoexplorevariouswhat-ifscenariosinordertoanalyzechangesinrevenuesorcostsorquantities.

TheBetaMuOmegaChi(BMOC)frater