COST-VOLUME-PROFIT RELATIONSHIPS Ing. Markéta Šeligová, Ph.D. MANAGERIAL ACCOUNTING/NANMU COST-VOLUME-PROFIT RELATIONSHIPS OUTLINE OF THE LECTURE 1.Cost-volume-profit (CVP) analysis 2. 2.Contribution margin 3. 3.Applications of CVP concepts 4. 4.Target profit analysis 5. 5.Sales mix 6. 6. 6. 6. 1. COST-VOLUME-PROFIT RELATIONSHIPS COST-VOLUME-PROFIT (CVP) ANALYSIS (1) •helps managers make many important decisions such as what products and services to offer, what prices to charge, what marketing strategy to use, and what cost structure to maintain • •its primary purpose is to estimate how profits are affected by the following five factors: –1. selling prices –2. sales volume –3. unit variable costs –4. total fixed costs –5. mix of product sold COST-VOLUME-PROFIT RELATIONSHIPS COST-VOLUME-PROFIT (CVP) ANALYSIS (2) •to simplify CVP calculations, managers typically adopt the following assumptions with respect these factors • –selling price is constant. The price of a product or service will not change as volume changes • –costs are linear and can be accurately divided into variable and fixed element. The variable element is constant per unit. The fixed element is constant in total over the entire relevant range • –in multiproduct companies, the mix of products sold remains constant COST-VOLUME-PROFIT RELATIONSHIPS CONTRIBUTION MARGIN •contribution margin is the amount remaining from sales revenue after variable expenses have been deducted • •thus, it is the amount available to cover fixed expenses and then to provide profits for the period • •contribution margin is used first to cover the fixed expenses, and then whatever remains goes toward profits • •if the contribution margin is not sufficient to cover the fixed expenses, then a loss occurs for the period COST-VOLUME-PROFIT RELATIONSHIPS CVP RELATIONSHIPS IN EQUATION FORM (1) •the contribution format income statement can be expressed in equation form as follows: • •Profit = (Sales - Variable expenses) - Fixed expenses • •When a company has only a single product, we can further refine the equation as follows: • •Sales = Selling price per unit X Quantity sold = P x Q •Variable expenses = Variable expenses per unit X Quantity sold = V x Q •Profit = (P x Q – V x Q) - Fixed expenses COST-VOLUME-PROFIT RELATIONSHIPS CVP RELATIONSHIPS IN EQUATION FORM (2) •it is often useful to express the simple profit equation in terms of the unit contribution margin (Unit CM) as follows: • •Unit CM = Selling price per unit - Variable expenses per unit = P – V •Profit = (P x Q - V x Q) - Fixed expenses •Profit = (P - V) x Q - Fixed expenses •Profit = Unit CM x Q - Fixed expenses COST-VOLUME-PROFIT RELATIONSHIPS CONTRIBUTION MARGIN RATIO (CM RATIO) (1) COST-VOLUME-PROFIT RELATIONSHIPS CONTRIBUTION MARGIN RATIO (CM RATIO) (2) •the CM ratio shows how the contribution margin will be affected by a change in total sales • •for example, CM ratio of 40% means that for each dollar increase in sales, total contribution margin will increase by 40 cents ($1 sales x CM ratio of 40%) • •net operating income will also increase by 40 cents, assuming that fixed costs are not affected by the increase in sales • •Generally, the effect of a change in sales on the contribution margin is expressed in equation form as: • Change in contribution margin = CM ratio x Change in sales • COST-VOLUME-PROFIT RELATIONSHIPS CONTRIBUTION MARGIN RATIO (CM RATIO) (3) •the relation between profit and the CM ratio can also be expressed using the following equations: • Profit = CM ratio x Sales – Fixed expenses •Or, in terms of changes, Change in profit = CM ratio x Change in sales – Change in fixed expenses COST-VOLUME-PROFIT RELATIONSHIPS APPLICATIONS OF CVP CONCEPTS COST-VOLUME-PROFIT RELATIONSHIPS BREAK - EVEN ANALYSIS COST-VOLUME-PROFIT RELATIONSHIPS BREAK-EVEN IN DOLLAR SALES COST-VOLUME-PROFIT RELATIONSHIPS TARGET PROFIT ANALYSIS (1) •target profit analysis is one of the key uses of CVP analysis. • •In target profit analysis, we estimate what sales volume is needed to achieve a specific target profit •to determine the unit sales and dollar sales needed to achieve a target profit, we can rely on the same two approaches - the equation method or the formula method • The Equation Method –Profit = Unit CM x Q – Fixed expense COST-VOLUME-PROFIT RELATIONSHIPS TARGET PROFIT ANALYSIS (2) COST-VOLUME-PROFIT RELATIONSHIPS THE MARGIN OF SAFETY COST-VOLUME-PROFIT RELATIONSHIPS OPERATING LEVERAGE COST-VOLUME-PROFIT RELATIONSHIPS THE DEFINITION OF SALES MIX (1) •refers to the relative proportions in which a company´s products are sold • •the idea is to achieve the combination, or mix, that will yield the greatest profit • •most companies have many products, and often these products are not equally profitable • •profits will depend to some extent on the company´s sales mix • •profits will be greater if high-margin rather than low-margin items make up a relatively large proportion of total sales • –changes in the sales mix can cause perplexing variations in a company´s profits • COST-VOLUME-PROFIT RELATIONSHIPS THE DEFINITION OF SALES MIX (2) •a shift in the sales mix from high-margin items to low-margin items can cause total profits to decrease even though total sales may increase • •a shift in the sales mix from low-margin items to high-margin items can cause the reverse effect - total profits may increase even though total sales decrease • •it is one thing to achieve a particular sales volume; it is quite another to sell the most profitable mix of products COST-VOLUME-PROFIT RELATIONSHIPS SALES MIX AND BREAK-EVEN ANALYSIS •if a company sells more than one product, break-even analysis is more complex than discussed to this point • •the reason is that different products will have different selling prices, different costs, and different contribution margins • •the break-even point depends on the mix in which the various products are sold • •If the sales mix changes, then the break-even point will also usually change COST-VOLUME-PROFIT RELATIONSHIPS COST-VOLUME-PROFIT RELATIONSHIPS COST-VOLUME-PROFIT RELATIONSHIPS COST-VOLUME-PROFIT RELATIONSHIPS COST-VOLUME-PROFIT RELATIONSHIPS COST-VOLUME-PROFIT RELATIONSHIPS