chapter 3: analysis of cost volume and...

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CHAPTER 3:

ANALYSIS OF COST–VOLUME AND

PRICING TO INCREASE

PROFITABILITY - CVP ANALYSIS

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Learning Objectives

1. Explain the features of cost-volume-profit (CVP)

analysis

2. Determine the breakeven point and output level

needed to achieve a target operating income

3. Explain how managers use CVP analysis in

decision making

4. Explain how sensitivity analysis helps managers

cope with uncertainty

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Learning Objectives

6. Use CVP analysis to plan variable and fixed costs

7. Apply CVP analysis in service and not-for-profit

organizations

8. Distinguish contribution margin from gross margin

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Learning Objective 1

Explain the Features of Cost-

Volume-Profit (CVP) Analysis

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Cost-Volume-Profit Analysis

Analysis of the behavior and relationship among

total revenues, total costs, and income as the units

sold, selling price, variable cost per unit, or fixed

costs change

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Steps in Decision Making

Identify the problem and uncertainties

Obtain information

Make predictions about the future

Make decisions by choosing among alternatives

Implement the decision, evaluate performance, and learn

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Contribution Margin

Difference between total revenues and total variable

costs

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Exhibit 3.1 - Contribution Income

Statement

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Contribution Margin Percentage

Calculating contribution margin per unit is

cumbersome when companies have multiple

products

It is contribution margin as a percentage, instead of

dollars

It is the contribution margin per dollar of revenue

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Expressing CVP Relationships

Three related ways in which cost-volume-profit

relationships can be analyzed:

Equation method

Contribution method

Graph method

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Equation Method

Based on the operating income equation:

This equation can be further expanded as:

Operating income = [(Selling price × Quantity of units sold) −

(Variable per unit × Quantity of units sold)] − Fixed costs

Operating income = Revenues − Variable costs − Fixed costs

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Contribution Margin Method

Uses the contribution margin per unit to calculate

the operating income

Operating income = [(Contribution margin per unit) × (Quantity

of units sold)] − Fixed costs

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Exhibit 3.2 - Graph Method

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Cost-Volume-Profit Assumptions

The number of units sold is the only revenue driver

and the only cost driver

Total costs can be separated into two components: a

fixed component and a variable component

When represented graphically, the behaviors of

total revenues and total costs are linear

Selling price, variable cost per unit, and total fixed

costs are known

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Learning Objective 2

Determine the Breakeven Point and

Output Level Needed to Achieve a

Target Operating Income

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Breakeven Point

Quantity of output sold at which total revenues

equal total costs

When there are multiple products, it is convenient to

calculate breakeven point directly in terms of

revenue

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Target Operating Income

Helps in determining the number of units that should

be sold to achieve a target operating income

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Exhibit 3.3 - Profit-Volume Graph

Shows how changes in the quantity of units sold

affect operating income

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Target Net Income and Income

Taxes

Helps managers asses the effects of their decisions

on operating income after taxes

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Learning Objective 4

Explain How Managers Use CVP

Analysis in Decision Making

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Using CVP Analysis for Decision

Making

Managers use CVP analysis to guide other decisions

Decision to advertise

Decision to reduce selling price

Determining target prices

It helps managers make product decisions by

estimating the expected profitability of these

decisions

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Learning Objective 5

Explain How Sensitivity Analysis

Helps Managers Cope with

Uncertainty

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Sensitivity Analysis

“What-if ” technique used to recognize uncertainty

by examining how an outcome will change if the

original predicted data or assumption change

Broadens managers’ perspectives to possible

outcomes that might occur before the company

commits to funding the project

Electronic spreadsheets enable managers to

systematically and efficiently conduct analyses

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Margin of Safety

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Learning Objective 6

Use CVP Analysis to Plan

Variable and Fixed Costs

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Alternative Fixed-Cost/Variable-Cost

Structures

Managers have the ability to choose the levels of

fixed and variable costs in their cost structures

Sensitivity analysis helps examine the risks and

returns in a company cost structure

As fixed costs are substituted for variable costs

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Operating Leverage

Describes the effects that fixed costs have on

changes in operating income as changes occur in

units sold and contribution margin.

Organizations with high proportion of fixed costs

will have higher operating leverage

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Learning Objective 7

Apply CVP Analysis to a

Company Producing Multiple

Products

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Effects of Sales Mix on CVP

Formulae presented to this point have assumed a

single product is produced and sold

Most companies sell a large variety of products

Sales mix is the quantities or proportions of various

products or services that constitute total unit sales of

a company

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Effects of Sales Mix on CVP

Total number of units that must be sold to break

even in a multiproduct company depends on the

sales mix

CVP analysis with multiple products is performed by

calculating a weighted average contribution margin

based upon a constant sales mix percentage

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Calculation of Break-even-point With

Multiple Products

Assume that the budgeted sales mix will not change

at different levels of total unit sales

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Effects of Sales Mix on Income

Many different sales mixes can result a given

contribution margin

Choice of sales mix affects the operating income of

a company

Companies adjust their sales mix to respond to

demand changes

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Learning Objective 8

Apply CVP Analysis in Service

and Not-for-Profit Organizations

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CVP Analysis in Service and Not-for-

Profit Organizations

To apply CVP analysis, the focus must be on

measuring organizational output

Measuring output is different from the tangible units

sold by manufacturing and merchandising

companies

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Learning Objective 9

Distinguish Contribution Margin

from Gross Margin

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Contribution Margin v/s Gross

Margin

Contribution margin

indicates how much of

a company’s revenues

are available to cover

fixed costs

Gross margin

measures how much a

company can charge

for its products over

and above the cost of

acquiring or producing

them

Contribution Margin Gross Margin