Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-1 Outline CVP analysis and the break-even point Graphing CVP relationships Target net profit CVP analysis for management decisions CVP analysis with multiple products Including income taxes in CVP analysis Assumptions underlying CVP analysis An activity-based approach to CVP analysis Financial planning models Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-2 What is cost volume profit (CVP) analysis? Determines the effect of changes in an organisations sales volume on its costs, revenue and profit Provides answers to a series of short- term changes can determine the impact on revenue and costs quickly Can be used in both profit-seeking and not-for-profit organisations
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-3 The break-even point The volume of sales where the total revenues and costs are equal, and the operation breaks even At this level of sales, there is no profit or loss The break-even point can be calculated for an entire organisation or for individual projects or activities
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-4 Break-even formulas Fixed costs Break-even point (in units) = Unit contributi on margin
Fixed costs Break-even point (in sales dollars) = Unit contributi on margin ratio
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-6 Graphing cost volume profit relationships Shows how costs, revenue and profits change as sales volume changes Five steps Draw the axes of the graph Draw the fixed cost line Draw the total cost line Draw the total revenue line Break-even point where the total revenue and total cost lines intersect Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-7 Cost volume profit graph, Melbourne Theatre Company production Calypso
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-8 Profit volume (PV) graph Shows the total amount of profit or loss at different sales volumes The graph intercepts the vertical axis at the amount equal to the fixed costs The break-even point is the point at which the total profit/loss line crosses the horizontal axis
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-10 Target net profit A desired profit level determined by management The break-even formula can be used to determine the sales volume needed to achieve a particular target profit Fixed costs + target net profit Target sales volume (in units) = Unit contributi on margin Fixed costs + target net profit Target sales volume (in dollars) = Unit contributi on ratio
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-11 Using CVP analysis for management decision making Safety margin Difference between the budgeted sales revenue and break-even sales revenue Changes in fixed costs Percentage change in fixed costs will lead to a similar increase in the break- even point (in units or dollars) Changes in the contribution margin per unit Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-12 Multiple changes in key variables May involve, for example Decreasing variable costs per unit Increasing selling prices Undertaking a new advertising campaign Leasing a new office An incremental approach to analysis Focuses on the differences in the total contribution margin, fixed costs and profits under the two alternatives
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-13 CVP analysis with multiple products Sales mix The relative proportions of each type of product sold by the organisation Weighted average unit contribution margin The average of the products unit contribution margins, weighted by the sales mix Fixed costs Break-even point = Weighted average unit contribution margin
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-14 Profit volume graph with multiple products, Melbourne Theatre Company production Calypso
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-15 Including income taxes in CVP analysis Sales volume required to earn net profit after tax
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-16 Assumptions underlying CVP analysis The behaviour of total revenue is linear The behaviour of total costs is linear over a relevant range For both variable and fixed costs, sales volume is the only cost driver The sales mix remains constant over the relevant range In manufacturing firms, the levels of inventory at the beginning and end of the period are the same Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-17 CVP analysis and longer-term decisions CVP analysis is usually regarded as a short-term or tactical decision tool Classification of costs as variable or fixed is usually based on cost behaviour over the short term The financial impact of long-term decisions is best analysed using capital budgeting techniques Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-18 Treating CVP analysis with caution CVP analysis is a simplified model The usefulness of CVP analysis may be greater in less complex, smaller firms, or for stand-alone projects For larger, more complex firms, CVP analysis can also be valuable as a decision tool for the planning stages of new projects and ventures Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-19 An activity-based approach to CVP analysis
ABC categorises activities at unit,
batch, product or facility level Batch, product and facility activities are non-volume related activity costs Total batch, product and facility level costs Break-even point = Selling price per unit - costsper unit
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-22 Limiting assumptions of CVP analysis using activity-based costs Total batch level costs are dependent on the batch size and the break- even/target production level Management may change the batch size at certain production volume levels More complex models are needed where there are multiple products Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-23 Including customer-related costs in CVP analysis Profit = Sales revenue (unit level costs + batch level costs + product level costs + order level costs + customer level costs + marketing level costs + facility level costs) Copyright 2015 McGraw-Hill Education (Australia) Pty Ltd Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-24 Financial planning models Sensitivity analysis and CVP analysis Can be run using spreadsheet software Goal seek approaches The analyst specifies the outcome, and the software specifies the necessary inputs What-if analysis The analyst specifies changes in assumptions and data to examine the effect of these changes on the outputs
Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-26 Summary CVP analysis is a decision tool The break-even point is the sales level at which sales cover costs there is zero profit The break-even formula can be modified to calculate target profit CVP analysis has several assumptions which limit its usefulness for decision making Activity-based approaches and financial planning modelling can provide more sophisticated models