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# Chapter 21

Cost-Volume-
Profit Analysis

## © 2016 Pearson Education Ltd.

Learning Objective 1

## Determine how changes

in volume affect costs

## © 2016 Pearson Education Ltd. 21-2

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

Variable Costs

## • Variable costs remain constant per unit

but change in total as volume changes.

Variable Costs

Fixed Costs

Fixed Costs

Fixed Costs

Mixed Costs

components.

Mixed Costs

High-Low Method

## • A method to separate mixed costs into

variable and fixed components is the
high-low method.

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.

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.

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.

## © 2016 Pearson Education Ltd. 21-14

Relevant Range and Relativity

## • The relevant range is the range of

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

## © 2016 Pearson Education Ltd. 21-15

Learning Objective 2

Calculate operating
income using contribution
margin and contribution
margin ratio

## © 2016 Pearson Education Ltd. 21-16

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

## © 2016 Pearson Education Ltd. 21-17

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.

## © 2016 Pearson Education Ltd. 21-18

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.

## © 2016 Pearson Education Ltd. 21-19

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.

## © 2016 Pearson Education Ltd. 21-20

Contribution Margin Income
Statement

## © 2016 Pearson Education Ltd. 21-21

Learning Objective 3

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

## © 2016 Pearson Education Ltd. 21-22

How Is Cost-Volume-Profit (CVP)
Analysis Used?
• Managers use information about cost
• 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).

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.

## © 2016 Pearson Education Ltd. 21-24

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

## © 2016 Pearson Education Ltd. 21-25

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.

## © 2016 Pearson Education Ltd. 21-26

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.

## © 2016 Pearson Education Ltd. 21-27

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:

## © 2016 Pearson Education Ltd. 21-28

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

## © 2016 Pearson Education Ltd. 21-29

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.

## © 2016 Pearson Education Ltd. 21-30

Breakeven Point—A Variation of
Target Profit

## © 2016 Pearson Education Ltd. 21-31

CVP Graph—A Graphic Portrayal

## © 2016 Pearson Education Ltd. 21-32

Learning Objective 4

## Use CVP analysis to

perform sensitivity
analysis

## © 2016 Pearson Education Ltd. 21-33

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.

## © 2016 Pearson Education Ltd. 21-34

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.

## © 2016 Pearson Education Ltd. 21-35

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.

## © 2016 Pearson Education Ltd. 21-36

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.

## © 2016 Pearson Education Ltd. 21-37

How Is CVP Analysis Used for
Sensitivity Analysis?

## © 2016 Pearson Education Ltd. 21-38

Learning Objective 5

## Use CVP analysis to

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

## © 2016 Pearson Education Ltd. 21-39

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

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.

## © 2016 Pearson Education Ltd. 21-41

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.

## © 2016 Pearson Education Ltd. 21-42

Operating Leverage

## • For Company A, the percentage change in

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

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.

Sales Mix

Sales Mix