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CHAPTER 3

DEVELOPING A BUSINESS PLAN:

COST-VOLUME-PROFIT ANALYSIS

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Chapter Overview

Since the future is uncertain and circumstances are likely to change, why should a company bother to plan?

What should a company include in its business plan?

How does accounting information contribute to the planning process?

What must decision makers be able to predict in order to estimate profit at a given sales volume?

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How can decision makers predict the sales volume necessary for estimated revenues to cover estimated costs?

How can decision makers predict the sales volume necessary to achieve a target profit?

How can decision makers use accounting information to evaluate alternative plans?

Chapter Overview

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Planning in a New Company

Planning is an ongoing process for successful

companies.

A business plan is an evolving report that

describes a company’s goals and its current

plans for achieving these goals.

A business plan is used by both internal and

external users.

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The Business Plan

A business plan typically includes:

1. A description of the company,

2. A marketing plan,

3. A description of the operations of the company, and,

4. A financial plan.

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The Financial Plan

A major component of a company’s

business plan is the financial plan.

The purpose of this plan is to identify

the company’s capital requirements,

sources of capital, as well as to

describe the company’s projected

financial performance.

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Sources of Capital

Short-term capital represents those resources

raised by the business that will be repaid

within a year or less.

Examples include buying inventory on credit

from a supplier or acquiring a line of credit

from the bank that allows a company to

borrow money “as needed.”

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Sources of Capital

Long-term capital represents resources

raised by the business from investors or

creditors which will be repaid or returned in

more than a year.

Examples include cash investments by

owners, selling stock to investors, or

arranging long-term financing with a bank.

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Projected Financial Performance

This section of the financial plan projects how the company will perform under various scenarios.

For example, Sweet Temptations might ask “What will our profit be if we sell only 800 boxes of chocolate? How will it change if we sell 1,300 boxes of chocolate?”

The financial performance section is supported by cost-volume-profit analysis and budgets.

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Cost-Profit-Volume (CVP) Analysis

CVP analysis shows how profit will be affected by alternative sales volumes, selling prices, and costs.

CVP analysis is based on a simple profit computation that establishes a relationship between revenues and costs.

In order to use CVP analysis effectively, decision makers must understand how costs behave at different volume or activity levels.

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Fixed costs are constant in total for a specific

time period; they are not affected by

differences in volume during that same period.

Fixed costs are depicted by the horizontal

straight-line on a graph, indicating that the

cost will be the same (fixed) over different

volumes levels.

Fixed Cost Behavior

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Fixed Cost BehaviorExhibit 3-3

As Sweet Temptation’s sales volume increases, monthly rent remains constant at $1,000 per month.

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Variable costs change in total in a time period in direct proportion to the changes in volume.

Because variable costs change in direct proportion to the changes in volume, the cost per unit is constant.

Variable costs are depicted by a sloping line on a graph, indicating that the costs will increase or decrease in proportion to different volume levels.

Variable Cost Behavior

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Variable Cost BehaviorExhibit 3-4

As Sweet Temptation’s sales volume increases, variable costs increase proportionately.

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Total Cost Behavior

Total costs at any volume are the sum of fixed costs and variable costs at that volume.

The CVP equation for total costs = fixed costs (f) + variable costs per unit (v) times the volume (X).

Total costs

= f +

v(X)

Sales Volume

To

tal

Co

sts

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Total Cost BehaviorExhibit 3-5

Total Costs = f + v(X)Total Costs = $3,850 + $4.50 (1,000)Total Costs = $8,350

Assuming Sweet Temptation’s fixed costs are $3,850 and variable costs are $4.50 per unit, total costs = $8,350 at a sales volume of 1,000 units.

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Once the total cost relationship is defined, a company can then project its costs at different levels of sales volume.

The equation for computing net income can be expressed in the following format for CVP analysis:

Profit Computations

Revenues - Variable Costs - Fixed Costs = Profit

Total Expenses

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Break-even point is the point at which total revenues equal total costs, so there will be no profit or no loss.

Break-Even Point

Revenues - Variable Costs - Fixed Costs = Profit

Total Expenses

$7,000 $7,000 $0

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Profit Graph for Sweet

TemptationsExhibit 3-7

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A key concept in CVP analysis is called “contribution margin.”

Contribution margin equals the difference between estimated total sales revenue and estimated total variable costs.

Contribution Margin

Estimated total sales revenues ($10/unit x 10,000 units) 100,000$ Estimated total variable costs ($4/unit x 10,000 units) 40,000$ Contribution margin ($6/unit x 10,000 units) 60,000$

Sales price per unit 10$ 100%Variable cost per unit 4$ 40%Contribution margin per unit 6$ 60%

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Using CVP analysis, a $6/unit contribution margin can be interpreted as follows:

For every $1 of sales (or increase in sales), a company will earn 60%, or $.60 to contribute to covering fixed costs and operating profit.

Contribution Margin

Estimated total sales revenues ($10/unit x 10,000 units) 100,000$ Estimated total variable costs ($4/unit x 10,000 units) 40,000$ Contribution margin ($6/unit x 10,000 units) 60,000$

Sales price per unit 10$ 100%Variable cost per unit 4$ 40%Contribution margin per unit 6$ 60%

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A contribution margin of $6/unit, or 60%, would add $0.60 in operating profit for every additional dollar of sales once fixed costs are covered, as illustrated in the table below.

Contribution Margin

+ $1 sales + $2 sales + $3 sales

Sales $10.00 $11.00 $12.00 $13.00VC (40%) ($4.00) ($4.40) ($4.80) ($5.20)FC ($6.00) ($6.00) ($6.00) ($6.00)Profit $0.00 $0.60 $1.20 $1.80

CM % 60% 60% 60% 60%

Behavior Patterns of Contribution Margin

Break-even point

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With an understanding of contribution margin and fixed costs, CVP analysis can be used to project profit at different levels of sales volume, using the profit equation below:

Showing CVP Relationships

Revenues - Variable Costs - Fixed Costs = Profit

Total Expenses

Selling price/unit X unit

sales volume

Variable cost/unit X unit sales volume

Total fixed costs

Profit (for a given sales

volume)

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Assume Sweet Temptations sells boxes of chocolate at $10 per unit. Variable costs are $4.50 per unit and fixed costs are $3,850. How would the break-even point in units be calculated?

Calculating Break-Even Point

Selling price/unit x - Variable cost/unit x - Total fixed = ProfitUnit sales volume Unit sales volume costs

($10.00X - $4.50X) - $3,850 = 0$5.50X = $3,850

X = $3,850/$5.50X = 700

Unit sales volume = X

Break-even point in unitsFixed costs

Contribution margin per unit

Simplified, break-even point in units can be defined as:

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By inserting the quantities back into the basic

CVP equation, proof is obtained that 700 units

equals the break-even point:

Calculating Break-Even Point

Revenues ($10 x 700 units) 7,000$ Variable costs ($4.50 X 700 units) 3,150$ Fixed Costs 3,850$ Profit -$

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Selling price/unit X - Variable cost/unit X - Total fixed = ProfitUnit sales volume Unit sales volume costs

($10.00X - $4.50X) - $3,850 = $110$5.50X = $3,850

X = $3,850 + $110/$5.50X = 720

Unit sales volume = X

Assume Sweet Temptations sells boxes of chocolate at $10 per unit. Variable costs are $4.50 per unit and fixed costs of $3,850. How many units have to be sold to earn a profit of $110?

Calculating a Desired Profit

Target profit in unitsFixed costs + Desired profit

Contribution margin per unit

Simplified, desired profit point in units can be defined as:

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By inserting the quantities back into the basic

CVP equation, proof is obtained that 720 units

will generate the desired profit:

Revenues ($10 x 720 units) 7,200$ Variable costs ($4.50 X 720 units) 3,240$ Fixed Costs 3,850$ Profit 110$

Calculating a Desired Profit

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Assumption 1: Selling price increases but other costs do not change.

Assumption 2: Fixed costs increase but selling price and variable cost do not change.

Assumption 3: Variable costs increase but sales and fixed costs do not change.

Planning with CVP Analysis

Using CVP analysis, a company can project the impact on profits by changing variables.

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Reflection How would I calculate break-

even point if there is an increase in

fixed costs?

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Selling price/unit X - Variable cost/unit X - Total fixed = ProfitUnit sales volume Unit sales volume costs

($10.00X - $4.50X) - $4,850 = 0$5.50X = $4,850

X = $4,850/$5.50X = 882

Assume Sweet Temptations sells boxes of chocolate at $10 per unit. Variable costs are $4.50 per unit and fixed costs are $3,850. If fixed costs increase by $1,000, how would the break-even point in units be calculated?

Calculating Break-Even Point When Fixed Costs Change

New break-even point in unitsThe change in fixed costs

would simply be included in the basic CVP equation