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Chapter 21

Cost-Volume-
Profit Analysis

© 2016 Pearson Education Ltd.


Learning Objective 1

Determine how changes


in volume affect costs

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How Do Costs Behave When
There Is a Change in Volume?
• Some costs change as the volume of sales
increases or decreases. Other costs are
not affected by changes in volume.
• Different types of costs are:
– Variable costs
– Fixed costs
– Mixed costs

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Variable Costs

• Variable costs remain constant per unit


but change in total as volume changes.

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Variable Costs

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Fixed Costs

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Fixed Costs

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Fixed Costs

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Mixed Costs

• Mixed costs have both fixed and variable


components.

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Mixed Costs

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High-Low Method

• A method to separate mixed costs into


variable and fixed components is the
high-low method.

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High-Low Method

• Use three steps to separate the variable


and fixed costs.
• Step 1: Identify the highest and lowest
levels of activity and calculate the variable
cost per unit.

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High-Low Method

• Now that we have calculated the variable


costs per unit, we can calculate the
portion of the mixed costs that relates to
the fixed costs.
• Step 2: Calculate the total fixed costs.

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High-Low Method

• Using the variable costs per unit and the


fixed costs per unit, we can determine the
total mixed costs at various levels of
productivity.
• Step 3: Create and use an equation to
show the behavior of a mixed cost.

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Relevant Range and Relativity

• The relevant range is the range of


volume where total fixed costs and
variable costs per unit remain constant.

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Learning Objective 2

Calculate operating
income using contribution
margin and contribution
margin ratio

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What Is Contribution Margin, And How
Is It Used to Compute Operating
Income?
• A traditional income statement classifies
costs by function:
– Product costs
– Period costs
• A contribution margin income
statement classifies costs by behavior:
– Variable costs
– Fixed costs

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Contribution Margin

• The difference between net sales revenue


and variable costs is the contribution
margin.
• It is called contribution margin because it
is the amount that contributes to covering
fixed costs.

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Unit Contribution Margin

• The contribution margin can be expressed


as a unit amount.
• Note: The terms unit contribution margin
and contribution margin per unit are used
interchangeably.

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Contribution Margin Ratio

• A third way to express contribution margin


is as a ratio.
• Contribution margin ratio is the ratio of
contribution margin to net sales revenue.

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Contribution Margin Income
Statement

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Learning Objective 3

Use cost-volume-profit
(CVP) analysis for profit
planning

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How Is Cost-Volume-Profit (CVP)
Analysis Used?
• Managers use information about cost
behavior to make business decisions.
• Cost-volume-profit (CVP) analysis is a
planning tool that looks at the
relationships among costs and volume and
how they affect profits (or losses).

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Assumptions

• The price per unit does not change as


volume changes.
• Managers can classify each cost as
variable, fixed, or mixed.
• The only factor that affects total costs is
change in volume, which increases or
decreases variable and mixed costs.
• Fixed costs do not change.
• There are no changes in inventory levels.

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Target Profit—Three Approaches

• CVP analysis can be used to estimate the


amount of sales needed to achieve a
target profit.
• There are three methods of estimated
sales required to make a profit:
– Equation approach
– Contribution margin approach
– Contribution margin ratio approach

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The Equation Approach

• An equation can be used to estimate the


number of units a company needs to sell
to achieve target profit or total sales
revenue.

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The Equation Approach

• If Smart Touch Learning desires a target


profit of $6,000, using the equation
approach, it finds it needs to sell 80 units.

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The Contribution Margin Approach

• The contribution margin approach is a


shortcut method of computing the
required sales in units.
• The equation approach is rewritten to
derive the following equation:

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Contribution Margin Ratio
Approach
• The contribution margin ratio approach
computes required sales in terms of sales
dollars rather than in units.

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Breakeven Point—A Variation of
Target Profit
• The breakeven point calculation is a
variation of the target profit calculation.
• The breakeven point is the point at
which total revenues equal total costs.
• The same three approaches used for
target profit can be used to determine the
breakeven point.

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Breakeven Point—A Variation of
Target Profit

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CVP Graph—A Graphic Portrayal

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Learning Objective 4

Use CVP analysis to


perform sensitivity
analysis

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How Is CVP Analysis Used for
Sensitivity Analysis?
• Managers can use CVP relationships to
conduct sensitivity analysis.
• Sensitivity analysis is a “what if”
technique that estimates profit or loss
results if sales price, cost, volume, or
underlying assumptions change.

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Changes in the Sales Price

• If the sales price changes from $500 to


$475, the number of units needed to
breakeven increases from 54 to 60.

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Changes in Variable Costs

• If one of Smart Touch Learning’s suppliers


raises prices and variable costs increase
from $275 to $285, the number of units
needed to break even increases from
54 to 56.

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Changes in Fixed Costs

• If Smart Touch Learning’s fixed costs


increase from $12,000 to $15,000, the
number of units needed to break even
increases from 54 to 67.

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How Is CVP Analysis Used for
Sensitivity Analysis?

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Learning Objective 5

Use CVP analysis to


calculate margin of safety,
operating leverage, and
multiproduct breakeven
points

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What Are Some Other Ways CVP
Analysis Can Be Used?
• CVP analysis can be used for estimating
target profits and breakeven points, as
well as sensitivity analysis.
• Three additional applications of CVP are:
– Margin of safety
– Operating leverage
– Sales mix

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Margin of Safety

• Margin of safety is the excess of


expected sales over breakeven sales.

• Used to evaluate the risk of current


operations and their plans for the future.

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Operating Leverage

• The cost structure of a company is the


proportion of fixed costs to variable costs.
• Operating leverage predicts the effects
that fixed costs will have on changes in
operating income when sales volume
changes.
• The degree of operating leverage can be
measured by dividing the contribution
margin by the operating income.

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Operating Leverage

• For Company A, the percentage change in


operating income will be 2.5 times the
percentage change in sales.

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Sales Mix

• Most companies sell more than one


product.
• Sales price and variable costs differ for
each product.
• Sales mix, or product mix, is the
combination of products that make up
total sales.

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Sales Mix

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Sales Mix

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