c v p analysis

8/8/2019 C v P Analysis

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Week Seven

C-V-P Analysis

Cost-Volume-Profit Analysis

CVP analysis is a method for analyzing how operatingdecisions and marketing decisions affect profit

Managers use CVP analysis to guide strategic decision

e.g. a decision about which feature to add to an existingproduct; how much to advertise, whether to expand intonew markets, and how to price the product.

These decision can affect SP, VC, FC units sold and OI

CVP analysis helps managers in making decision by

estimating the expected profitability of the choicesQ. What are the assumption of C-V-P analysis


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CVP analysis can be used in:

Setting prices for products and services

Determining whether to introduce a new product orservice

Replacing a piece of equipment

Determining breakeven point

Making Make-or-buy (i.e., sourcing) decisions

Determining the best product mix

Performing strategic what-if (sensitivity) analysis

Strategic Role of CVP Analysis

CVP analysis can help a firm choose its strategic position

and execute its strategy by providing an understanding of

how changes in sales volume affect costs and profits

This process is most important for cost leadership firmsduring the manufacturing stage

Differentiation firms use CVP analysis to assessprofitability and desirability of new products and features


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Profit Targets and Sales Revenue

The equation and contribution margin methods can be usedto determine the sales volume needed to achieve a targetprofit.

i.e. how many units must be sold to earn a certain amountof operating income.

Using equation method-

To calculate revenues needed to earn a certain amountof operating income -

Sales = Variable expenses + Fixed expenses + Profits

Using contribution margin method

To calculate the quantity must be sold to earn a target profit

OR

Q = [ (FC + TP) / CMPU ]

To calculate revenues needed to earn a certain amount ofoperating income

ORRevenues = [ (FC + TP) / CM% ]

Fixed expenses + Target profitUnit contribution margin

=Unit sales to attain

the target profit

Fixed expenses + Target profitContribution margin ratio

=Unit sales to attain

the target profit


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Risk and Uncertainty in DecisionMaking

Strategic decisions invariably involve riskand uncertainty

Risk differ from uncertainty.

Under risk the probability distribution of variables areknown, whereas, under uncertainty they are not known.

Q. What are the concepts managers apply to deal with risk

and uncertainty in the context of CVP?

Margin of safety (MS)

Is the unit sold (revenue earned) or expected to be sold

(revenue expected to be earned) above the break-evenvolume.

MS in unit = (Sales in unit BEP in unit)

It is a crude measures of risk

because there are unknown events that can lowersales below the expected level.

It states the amount by which sales can drop before

losses begin to incurred


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Operating Leverage (OL):

Operating leverage provides information concerning therelationship between a companys variable and fixed costs.

Give indication how sensitive net income is to percentagechange in sales.

OL act as multiplier

Generally, companies that are highly labor intensive tend tohave higher variable costs and lower fixed costs, and thus,low operating leverage. The reverse is also true for capitalintensive companies.

Degree of OL = CM / Profit

A higher DOL value indicates a higher risk in the sensethat a given change in sales will have a relatively greater

% impact on profits

Firms with a higher OL will experience greater reductionsin profits as sales decrease.

The DOL can be thought of as the extent to which fixedcosts characterize the cost structure of an organization:

the higher the percentage of fixed costs, the higher theDOL (and therefore the higher the operating risk)


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Characteristics of a highly leveraged company

Generally have high contribution margin since theirvariable costs tend to be lower. However, the higher fixedcosts would mean that the BEP would also be high.

If selling price is relatively stable, the volume of saleswould have high impact on profit/loss. A small increase insales volume can have a major impact on profit/loss withina given relevant range.

It is important to reduce operational leverage duringperiods of economic distress

Actual sales500 Bikes

Sales 250,000$

Less: variable expenses 150,000

Contribution margin 100,000

Less: fixed expenses 80,000

Net income 20,000$

$100,000$20,000 = 5

Example: Assume following information is gathered fromBicycle division of Racing Bicycle company.

At Racing Bicycle co., the degree of

operating leverage is =


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If sales are higher (in certain percentage) then theexpected/projected sales, then it has effect on the percentagechange in profits.

% change in profits= DOL x % change in sales

For example-with an operating leverage of 5, if Racing increasesits sales by 10%, net operating income would increase by 50%.

Percent increase in sales 10%

Degree of operating leverage 5

Percent increase in profits 50%Heres the verification!

Actual sales

(500)

Increased

sales (550)

Sales 250,000$ 275,000$

Less variable expenses 150,000 165,000Contribution margin 100,000 110,000

Less fixed expenses 80,000 80,000

Net operating income 20,000$ 30,000$

10% increase in sales from

$250,000 to $275,000 . . .

. . . results in a 50% increase in

income from $20,000 to $30,000.


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Sensitivity Analysis

Sensitivity analysis is a what-if technique that manager use toexamine-

how a result will change if the original predicted data are notachieved (due to uncertainty) or if an underlying assumptionchanges.

Therefore, this analysis is the calculation of an amount givendifferent levels of a factor that influences that amount

In the context of CVP analysis, sensitivity analysis answer suchquestion as-

What will operating income be if the units sold decreased say by5% from the originally predicted?

What will operating income be if variable cost per unit increasesay by 10% from the originally predicted?

Multiple Product CVP Analysis

What is multiple product CVP Analysis?

method for analyzing how operating decisions andmarketing decisions affect profit when company sell

multiple products

Assumptions required:

Sales mix (i.e. ratio of products sold) is assumed constant

Fixed costs is not directly related to a particular product.

Basic approach to deal with multi-product situation is -

Determine the Total Sales dollars and Total quantity ofunits to be sold as well as the Sales and Units Sales of

the individual products


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Setting up the problem

The challenge of Multiple product CVP analysis is diminishedwhen you set up the problem correctly.

Create CM income statement for each product

Create a total column that is a summation of the differentproducts

Example: Setting up the problem

Assume that a company sells two products: Product A andProduct B. The sales prices are $10 for product A and $15for product B. Variable costs per unit are $8 for Product Aand $9 for Product B. The company has total fixed costs of$5,000. Assume the company expects to sell 1,500 units ofProduct A and 500 units of Product B.

UNITS 1,500 500 2,000

Product A Product B TOTAL

Sales $ 15,000 $ 7,500 $ 22,500

Variable costs $ (12,000) $ (4,500) $ (16,500)

Contribution Margin $ 3,000 $ 3,000 $ 6,000

Fixed Costs $ (5,000)

Net Income $ 1,000


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Weighted Average CM and CM%Weighted Average CM

Take the Total CM from total column ($6,000 in example) anddivide by total units (2,000 in example).

In example this gives a Weighted Average CM of $3 per unit.UNITS 1,500 500 2,000


Sales $ 15,000 $ 7,500 $ 22,500

Variable costs $ (12,000) $ (4,500) $ (16,500)



Net Income $ 1,000

Weighted Average CM is

$6,000/2,000 units = $3/unit

Weighted Average CM%

Take the CM from the TOTAL column ($6,000 in example) anddivide by the Sales from the total column ($22,500 in example).

$6,000 / $22,500 = 26.67% (.2667)

UNITS 1,500 500 2,000


Sales $ 15,000 $ 7,500 $ 22,500

Variable costs $ (12,000) $ (4,500) $ (16,500)



Net Income $ 1,000

Weighted Average CM%

$6,000 / $22,500 = 26.67%


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Calculating the Breakeven Point in Units Use the formula you already know, but use weighted average

CM:

Breakeven units = (FC + Targeted Profit) / Wt. avg. CM

This gives the TOTAL number of units to be sold at the breakevenpoint. Then determine how many of Product A and Product B will besold at the breakeven point.

UNITS 1,500 500 2,000


Sales $ 15,000 $ 7,500 $ 22,500

Variable costs $ (12,000) $ (4,500) $ (16,500)



Net Income $ 1,000

Breakeven Units:

(5000 + 0) / 3 = 1,667 (rounded)

The Allocation to Determine Units of EachProduct Sold at the Breakeven Point

Allocate Total Units to each product Based on ExpectedUnits Proportion

Must assume that the company will continue to sell the products

in fixed proportions.

In this example company sell 1,500 units of Product A and 500units of Product B.

So the proportion of units of Product A is 1,500/2,000 and theproportion of units of Product B is 500/2,000.

Take the total units to be sold at the breakeven point (1,667)and multiply by each products proportion

PRODUCT A: 1,667 * (1,500/2,000) = 1250 units

PRODUCT B: 1,667 * (500/2,000) = 417 units


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Calculating the Breakeven Point in

Sales Dollars Can be determined the breakeven point in Sales Dollars two

ways:

1. Calculate the Breakeven point in units and then multiply by thesales price per unit

2. Using the CM % method, directly calculate the Breakeven Point inSales Dollars

Multiply Breakeven Units by the sales price per unit

We know that the company will sell 1,250 units of Product A and 417units of Product B. Therefore,

Breakeven Sales Dollars of Product A:

1,250 * $10 per unit = $12,500

Breakeven Sales Dollars of Product B:

417 * $15 per unit = $6,255

Directly Calculate the Breakeven Sales Dollars Using CM %

Using the data from the Total column the Contribution Margin %

is 26.67%.

Using the Breakeven formula -determine the breakeven salesdollars for the company as a whole: (FC + Targeted Profit)/CM%

($5,000+0) / 26.67% = $18,748

Now allocation percentages of Sales Dollars for the individualproducts (based on given sales data) and Calculate SalesDollars using Proportions:

Product A: $18,748 * ($15,000 / $22,500) = $12,499

Product B: $18,748 * ($7,500 / $22,500) = $6,249


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Alternative Way to Deal withMultiple-Product CVP Analysis

Alternative approach to deal with multiple products situationis-

Convert the multi-product problem into a single-productproblem i.e.

identify the expected sales mix (in units) of the products.

Sales mix is the relative proportion in which a companys

products are sold. Different products have different selling prices, cost

structures, and contribution margins.

Determining sales Mix:

Can be measured in unit sold or in proportion of revenue.

But for CVP analysis, better to use sales mix expressed inunits.

e.g. say, sales mix of product X and Y is 3:2 whichmeans that it is expected to sell 3 units of X for ever 2units of Y.

After determining sales mix, firm can define the product it sellas package containing units X and Y.

By defining the product as package multiple product problemis converted into single product


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Now next step is to determine package contribution marginto calculate package BEP in units.

to calculate this the sales mix, individual product priceand variable cost are needed.

Therefore,

BE package = FC / Package contribution Margin

Limitation of the approach:

Complexity of the approach increase when the numberof product increases

ABC co. Produces and sells three types of yoga-trainingproducts: Video tapes, Basic equipment set and Yoga Mat. Lastyear Co. Sold 10,000 videos; 5,000 equipment sets and yoga

mats 20,000. Information on the three products is as follows:

Total fixed costs are $118,350

Required:

What is the sales mix of videos, equipment sets and yoga mats?

Calculate the BEQ of each product

Video Equipment Set Yoga Mat

Price $ 12.00 $ 15.00 $18

Variable cost perunit

4.00 6.00 $13


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Multiple-Product Break- Even

Analysis Example 11.9 Solution: R- 1 & 2

Product Sellingprice

VC CM Sales Mix Total CM

Videos $12 $4 $8 2 $16

Equip Sets 15 6 9 1 9

Yoga Mats 18 13 5 4 20

BE package ($118,350/$45) = 2,630

BE videos 2 x 2,630 = 5,260

Be Equip Sets 1 x 2,630 = 2,630

BE Yoga Mats 4 x 2,630 = 10,520

Conventional CVP Analysis andActivity-Based Costing (ABC)

Major limitation of traditional CVP Exclusive use of unit level activity cost drivers, i.e. does not

consider other categories of cost drivers

High probability of significant errors in cost estimation andprediction

ABC-costs are divided into units and non-units basedcategories

Therefore Activity based CVP is the expansion ofconventional CVP approach to incorporate non-unit activitycost drivers

Difficult to develop graphical relationships

Good way to begin is to make use of a contribution statementthat incorporates a hierarchy of cost drivers


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Note that :

If the assumption is made that say, total batch-level costsare fixed relative to the number of batches, bothapproaches will produce the same result

On the other hand, if the activity cost pool is a mixed cost,the ABC approach will provide a more accurate estimate ofcost because the traditional CVP approach treats all

activity costs that do not vary with output volume, (such asmachine setup, materials handling, inspection, andengineering, as fixed)

CVP Analysis in Service and Non-profit Organisations

To apply CVP analysis in service and nonprofitorganisation-

need to focus on measuring their output, which isdifferent from the tangible units sold.

Example of output measures in various service and nonprofitindustries:

Industry Measure of Output

Airlines Passenger miles

Hotels/motels Room-nights occupied

Hospitals Patient days

Universities Student credit-hours

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