Ch04 CVP.pdf

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Managerial Accounting

by James JiambalvoChapter 4:

Cost-Volume-Profit Analysis

Slides Prepared by:

Scott Peterson

Northern State University

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Chapter 4: Cost-Volume-

Profit-AnalysisChapter Themes:

Its all about how costs

change in total with

respect to changes inactivity.

C-V-P-A is linear.

You must be able to putall costs into either

variable or fixed costcategories.

Learning Objectives:1. Identify common cost behavior

patterns.

2. Estimate the relation between

cost and activity using accountanalysis, the high-low method,and scattergraphs.

3. Perform cost-volume-profit-analysis for single products.

4. Perform cost-volume-profit-analysis for multiple products.

5. Discuss the effect of operatingleverage.

6. Use the contribution margin perunit of the constraint to analyzesituations involving a resourceconstraint.

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Common Cost Behavior

PatternsTo perform Cost-Volume-Profit-Analysis (C-V-P-A), youneed to know how costs

behave when businessactivity (production volume,sales volume) changes.

Related Learning Objectives:1. Identify common cost behavior

patterns.







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Variable CostsBy definition, Variable Costsare costs that change (intotal) in response to changesin volume or activity. It isassumed, too, that therelationship between variablecosts and activity isproportional. That is, ifproduction volume increasesby 10%, then variable costsin total will rise by 10%.Examples include directlabor, raw materials and salescommissions.


patterns.







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Fixed CostsBy definition, Fixed Costs arecosts that do not change (intotal) in response to changes

in volume or activity.Examples includedepreciation, supervisorysalaries and maintenanceexpenses.


patterns.







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Mixed CostsMixed Costs are costs thatcontain both a variable costelement and a fixed cost

element. These costs aresometimes referred to assemi-variable costs. Anexample would be asalespersons salary where

she receives a base salaryplus commissions.


patterns.







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Cost Estimation MethodsManagers need to be able topredict (plan) costs at variousactivity levels. And becausecost information is often not

broken out in terms of fixedand variable components,managers use costestimation methods to do justthat. Four common methodsare:

1.Account analysis

2.Scattergraph

3.High-Low

4.Regression


patterns.







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Account AnalysisAccount Analysis is acommon approach toestimating fixed and variablecosts. This method requires

the manager to exerciseprofessional judgment toclassify costs into variableand fixed categories. Oncethis is done, total variablecosts are divided by theactivity level to determinevariable costs per unit ofactivity. Costs classified asfixed costs are used toestimate total fixed cost.


patterns.







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Scattergraph ApproachThe Scattergraph App roachuses cost information from anumber of reporting periods

(monthly for example) todetermine how costs changewith respect to changes inactivity. The periodic costdata are then plotted on agraph to get a visual pictureof the correlation betweencosts and activity levels. Asample Scattergraphappearson the next slide.


patterns.







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Sample ScattergraphRelated Learning Objectives:1. Identify common cost behavior

patterns.







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High-Low MethodUsing the same periodic dataas the scattergraph method,the High-Low Method may beused to estimate the fixed

and variable components atvarious levels of activity. Thismethod fits a line to thedata, but uses only the highand low data points. Here, theslope of the line (total costcurve) represents the variablecost. The Y-interceptrepresents the estimate of thefixed costs.


patterns.







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Regression AnalysisRegression Analysis is astatistical technique that usesall available data points to

estimate the slope andintercept. That is, unlike theHigh-Low method which usesonly the high and low datapoints, regression uses ALLof the data points to find thebest fit. It should be noted

that Regression Analysis is asuperior method of costestimation.


patterns.







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The Relevant RangeThe Relevant Range is theactivity level within whichcost behavior holds true.

Most models have limits andthis type of linear analysis isnot different. Above or belowthis range, forecasts of costbehavior may not beaccurate.


patterns.







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Cost-Volume-Profit AnalysisCost-Volume-Profit Analysis(C-V-P) explores therelationship between costs

(fixed and variable), activitylevels and profits. That is,once the variable and fixedelements have beendetermined using the toolsdiscussed in the precedingslides, we use the followingprofit equation: Profit = SP(x)- VC(x)TFC=Net Income.


patterns.







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Break-Even PointOne of the primary purposes ofC-V-P is to calculate the Break-Even Point. It simply representsthe number of units the firm

must sell to generate exactlyzero net incometo earn neitherprofit nor loss. Graphically, asshown in the next slide, Break-Even is the point where the salescurve and cost curve cross. Itshould be noted here that

managers are seldom interestedin merely breaking even. But theBreak-Even is an importantbenchmark!


patterns.







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Break-Even Point (Graphic)Related Learning Objectives:1. Identify common cost behavior

patterns.







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Margin of SafetyThe Margin of Safety is thedifference between theexpected level of sales and

break-even sales. It may beexpressed in units or dollarsof sales.


patterns.







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Contribution MarginThe Contribution Margin isthe difference between sellingprice and variable cost per

unit. It measures the amounteach unit sold contributes tocovering fixed cost (first) andincreasing profit (once fixedcosts are covered).

The relationship is as follows:

SP-VC


patterns.







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Contribution Margin RatioThe Contribution MarginRatio expresses thecontribution of every salesdollar to covering fixed cost

(first) and operating profit(second). It is calculated asfollows: SPVC

SP

In other words, for every

dollar of sales, X% of that willcontribute to covering thefixed costs, and once fixedcosts are covered X% ofevery dollar of sales will becontribute to net income.


patterns.







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What If AnalysisOnce the cost structure ismodeled (variable and fixedcosts are estimated)managers can do sensitivity

analyses or What IfAnalyses. This analysisexamines what will happen ifa particular action is taken.For example, what willhappen if fixed costs rise byX dollars and variable costsdecrease by Y dollars? Orwhat will happen if sellingprice is decrease by Zdollars?


patterns.







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Multiproduct AnalysisUp until now we looked at C-

V-P analysis for a singleproduct. The next fewslides examine C-V-P as it

applies to multipleproduct scenarios. Thereare two approaches wewill consider in thissection:

Contribution MarginApproach (for similarproducts)

Contribution Margin RatioApproach (forsubstantially different

products).


patterns.







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Contribution Margin ApproachAs indicated, if the productsunder analysis are similar(e.g., various flavors of icecream, various models of

boats), the Weighted AverageContribution MarginApproach can be used. Forexample, if the contributionmargin of product A is $8 andthe contribution margin ofproduct B is $5, and if twounits of B are sold for eachunit of A, the WeightedAverage Contribution Marginis $6.00.


patterns.







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Contribution Margin Ratio

ApproachIf the products under analysisare substantial different (e.g.,products in a department

store), the ContributionMargin Ratio Approachshould be used. It makes littlesense in this case to ask howmany units to break even.The question should be how

many dollars of sales tobreak even.


patterns.







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Assumptions in C-V-P AnalysisAs with most models, there

are certain assumptionswhich are made that

affect the validity of theanalysis.

Costs can be accuratelyseparated into variableand fixed components.

Fixed costs remain fixed. Variable costs per unit do

not change over therelevant range.


patterns.







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Operating LeverageOperating Leverage relates tothe level of fixed versusvariable costs in a firms cost

structure. The higher thedegree of fixed costs, themore operating leverage afirm is considered to have.Firms with lower variable andhigher fixed costs havehigher contribution margins.This translates into greaterprofit or loss as salesincrease or decrease.


patterns.







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ConstraintsIn the real world there areconstraints on how manyitems can be manufactured or

how much service can bedelivered. So the focus shiftsfrom contribution margin perunit to contribution marginper unit of the constraint.Examples of constraintsinclude manufacturing space,labor, parts and materialsetc


patterns.







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Copyright 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or

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Ch04 CVP.pdf