These lectures cover cost volume profit analysis, contribution margin ratio, break even point, target profit, margin of safety, operating leverage and break-even for multi-product.
Cost Volume Profit Analysis
Cost Volume Profit Analysis | Break -Even
Cost Volume Profit Analysis | Target Profit
CVP analysis is based on a simple model of how profits respond to prices, costs, and volume. This model can be used to answer a variety of critical questions such as what is the company’s break-even volume, what is its margin of safety, and what is likely to happen if specific changes are made in prices, costs, and volume.
A CVP graph depicts the relationships between unit sales on the one hand and fixed expenses, variable expenses, total expenses, total sales, and profits on the other hand. The profit graph is simpler than the CVP graph and shows how profits depend on sales. The CVP and profit graphs are useful for developing intuition about how costs and profits respond to changes in sales.
The contribution margin ratio is the ratio of the total contribution margin to total sales. This ratio can be used to quickly estimate what impact a change in total sales would have on net operating income. The ratio is also useful in break-even analysis.
Break-even analysis is used to estimate how much sales would have to be to just break even. The unit sales required to break even can be estimated by dividing the fixed expense by the unit contribution margin. Target profit analysis is used to estimate how much sales would have to be to attain a specified target profit. The unit sales required to attain the target profit can be estimated by dividing the sum of the target profit and fixed expense by the unit contribution margin.
The margin of safety is the amount by which the company’s current sales exceeds breakeven sales.
The degree of operating leverage allows quick estimation of what impact a given percentage change in sales would have on the company’s net operating income. The higher the degree of operating leverage, the greater is the impact on the company’s profits. The degree of operating leverage is not constant—it depends on the company’s current level of sales.
The profits of a multiproduct company are affected by its sales mix. Changes in the sales mix can affect the break-even point, margin of safety, and other critical factors.
Breakeven planning (a component of CVP analysis) determines the output level at which operating profit is zero. Breakeven analysis is used in planning and budgeting to assess the desirability of current and potential products and services. CVP analysis is also used in revenue planning to determine the sales volume needed to achieve a desired level of operating profit by adding desired profit to the breakeven equation. In cost planning, CVP analysis is used to find the required reduction in costs to meet desired profits or to find the required change in fixed cost for a given change in variable cost (or vice versa).
The basic CVP model can be expanded and made consistent with the traditional activity- based costing (ABC) model discussed in Chapter 5. Specifically, we expanded the CVP model to include batch-level costs, which under a traditional CVP model are treated as part of short- term fixed costs. Risk and uncertainty in CVP analysis are addressed through the use of two measures (mar- gin of safety and degree of operating leverage) as well as through sensitivity analysis. In terms of the latter, we discussed three approaches: simple “what-if” analyses, the preparation of decision tables, and the use of Monte Carlo simulation. With two or more products or services, we typically construct a CVP model by assuming that the products (or services) are sold in a predefined mix, determined either on the basis of physical units or sales dollars associated with the individual products.
The assumption of a sales mix allows us to calculate and use weighted averages for the contribution margin per unit and the contribution margin ratio. Alternatively, we can use the assumed sales mix to construct a “sales basket” of items. In this case, all amounts (e.g., contribution margin) are expressed on a per-sales-basket basis. Otherwise, the formulas used in the single-product case can be used for multiproduct profit planning. Not-for-profit organizations can also construct and use a CVP model for planning purposes. We presented the example of a municipal family support agency’s use of breakeven analysis to predict the effects of changing funding levels on the agency’s operations. A number of limitations must be considered in using breakeven analysis. If these assumptions are violated, then the use of more sophisticated profit-planning models should be considered.