Cost volume profit analysis

Chapter 18Cost volume profit analysis18-1Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithOutlineWhat is CVP analysis?The break-even pointGraphing CVP relationshipsTarget net profitUsing CVP analysis for management decisionsCVP analysis with multiple productsIncluding income taxes in CVP analysisPractical issues in CVP analysisAn activity-based approach to CVP analysisFinancial planning models18-2Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithCost volume profit (CVP) analysisA technique used to determine the effects of changes in an organisation’s sales volume on its costs, revenue and profitCan be used in profit-seeking organisations and not-for-profit organisations18-3Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithThe break-even pointThe volume of sales where the total revenues and costs are equal, and the operation breaks evenAt this level of sales, there is no profit or lossCan be calculated for an entire organisation or for individual projects18-4Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithBreak-even formulas18-5Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithTerminologyContribution margin (or variable costing) statementAn income statement that separates fixed and variable costs and calculates a contribution marginTotal contribution marginThe difference between the total sales revenue and the total variable costsThe amount available to cover fixed costs and then contribute to profitsUnit contribution marginThe difference between the sales price per unit and the variable cost per unit 18-6(cont.)Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithTerminology (cont.)Contribution margin ratioThe unit contribution margin divided by the unit sales priceThe proportion of each sales dollar available to cover fixed costs and earn a profitContribution margin percentageThe contribution margin ratio multiplied by 100The percentage of each sales dollar available to cover fixed costs and earn a profit18-7Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithGraphing cost volume profit relationshipsShows how costs, revenue and profits change as sales volume changesFive stepsDraw the axes of the graphDraw the fixed cost lineDraw the total cost lineDraw the total revenue lineBreak-even point—where the total revenue and total cost lines intersect18-8Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith18-9Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithProfit volume (PV) graphShows the total amount of profit or loss at different sales volumesThe graph intercepts the vertical axis at the amount equal to the fixed costsThe break-even point is the point at which the total profit/loss line crosses the horizontal axis18-10Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith18-11Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithTarget net profitA desired profit level determined by management The break-even formula can be sued to determine the target profit18-12Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithUsing CVP analysis for management decision makingSafety marginDifference between the budgeted sales revenue and break-even sales revenueGives a feel for how close projected operations are to the break-even pointChanges in fixed costsPercentage change in fixed costs will lead to a similar increase in the break-even point (in units or dollars)Different fixed costs may apply to different levels of sales/production volume, and provide more than one break-even point18-13Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Using CVP analysis for management decision making (cont.)Changes in the unit contribution marginChange in unit variable costs, leads to new unit contribution margin and new break-even pointAn increase in unit variable costs will increase the break-even pointAn increase in unit price will lower the break-even point18-14Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithMultiple changes in key variablesMay involve, for exampleIncreasing unit prices Increasing selling pricesUndertaking a new advertising campaignLeasing a new officeAn incremental approach to analysisFocuses on the differences in the total contribution margin, fixed costs and profits under the two alternatives18-15Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithCVP analysis with multiple productsSales mixThe relative proportions of each type of product sold by the organisationWeighted average unit contribution margin The average of the products’ unit contribution margins, weighted by the sales mix18-16Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith18-17Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithIncluding income taxes in CVP analysis18-18Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithAssumptions underlying CVP analysisThe behaviour of total revenue is linearThe behaviour of total costs is linear over a relevant rangeCosts can be categorised as fixed, variable or semivariableLabour productivity, production technology and market conditions do not changeThere are no capacity changes during the period under consideration18-19Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Assumptions underlying CVP analysis (cont.)For both variable and fixed costs, sales volume is the only cost driverThe sales mix remains constant over the relevant rangeIn manufacturing firms, the levels of inventory at the beginning and end of the period are the sameThus, the number of units produced and sold during a period are equal18-20Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithCVP analysis and longer-term decisionsCVP analysis is usually regarded as a short-term or tactical decision toolClassification of costs as variable or fixed is usually based on cost behaviour over the short termThe financial impact of long-term decisions is best analysed using capital budgeting techniquesTakes into account the time value of money18-21Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithTreating CVP analysis with cautionCVP analysis is merely a simplified modelThe usefulness of CVP analysis may be greater in less complex smaller firms, or stand-alone projectsFor larger firms, CVP analysis can be valuable as a decision tool for the planning stages of new projects and ventures18-22Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithAn activity-based approach to CVP analysisABC categorises activities as unit, batch, product or facility levelFacility, product and batch activities are non-volume activity costs18-23Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithLimiting assumptions of CVP analysis using activity-based costsTotal batch level costs are dependent on the batch size and the break-even/target production levelManagement may change the batch size at certain production volume levels and this will change the break-even volumeMore complex models are needed where there are multiple products18-24Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithFinancial planning modelsSensitivity analysis and CVP analysisAn approach that examines how an outcome may change if there are variations in the predicted data or underlying assumptionsCan be run using spreadsheet software, such as ExcelGoal seek approachesThe analyst specifies the outcome, and the software specifies the necessary inputsWhat-if analysisThe analyst specifies changes in assumptions and data to examine the effect of these changes on the outputs18-25Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithSummaryCVP analysis is a decision tool that can be used to assess the effects on changes in profit of changes in sales volume, sales price, sales mix and costsThe break-even point is the sales level at which sales covers costs—there are zero profitsThe break-even formula can be modified to calculate target profit, and to include sales mix and income taxesCVP analysis has several assumptions which limit its usefulness for decision makingActivity-based approaches and financial planning modelling can provide more sophisticated models18-26Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith