Accounting Discussion #2 (part A)

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PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA

Cost-Volume-Profit Relationships

Chapter 3

Chapter 3: Cost-Volume-Profit Relationships

Cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and profit by focusing their attention on the interactions among the prices of products, volume of activity, per unit variable costs, total fixed costs, and mix of products sold. It is a vital tool used in many business decisions such as deciding what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire.

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Learning Objective 3-1

Explain how changes in activity affect contribution margin and net operating income.

Learning objective 3-1 is to explain how changes in activity affect contribution margin and net operating income.

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Basics of Cost-Volume-Profit Analysis

Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted.

The contribution income statement is helpful to managers in judging the impact on profits of changes in selling price, cost, or volume. The emphasis is on cost behavior.

The contribution income statement is helpful to managers in judging the impact on profits of changes in selling price, cost, or volume. For example, let's look at a hypothetical contribution income statement for Racing Bicycle Company (RBC). Notice the emphasis on cost behavior. Variable costs are separate from fixed costs. The contribution margin is defined as the amount remaining from sales revenue after variable expenses have been deducted.

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Basics of Cost-Volume-Profit Analysis

CM is used first to cover fixed expenses. Any remaining CM contributes to net operating income.

Contribution margin is used first to cover fixed expenses. Any remaining contribution margin contributes to net operating income.

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The Contribution Approach

Sales, variable expenses, and contribution margin can also be expressed on a per unit basis. If Racing sells an additional bicycle, $200 additional CM will be generated to cover fixed expenses and profit.

Sales, variable expenses, and contribution margin can also be expressed on a per unit basis. For each additional unit Racing Bicycle Company sells, $200 more in contribution margin will help to cover fixed expenses and provide a profit.

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The Contribution Approach

Each month, RBC must generate at least $80,000 in total contribution margin to break-even (which is the level of sales at which profit is zero).

Each month Racing Bicycle must generate at least $80,000 in total contribution margin to break-even (which is the level of sales at which profit is zero).

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The Contribution Approach

If RBC sells 400 units in a month, it will be operating at the break-even point.

If RBC sells 400 units a month, it will be operating at the break-even point. Total sales will be 400 units times $500 each or $200,000, and total variable expenses will be 400 units times $300 each for $120,000. Contribution margin is exactly equal to total fixed expenses. Let’s see what happens if Racing sells one more bike or a total of 401 bikes.

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The Contribution Approach

If RBC sells one more bike (401 bikes), net

operating income will increase by $200.

If RBC sells one more bike (401 bikes), net operating income will increase by $200

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The Contribution Approach

We do not need to prepare an income statement to estimate profits at a particular sales volume. Simply multiply the number of units sold above break-even by the contribution margin per unit.

If Racing sells 430 bikes, its net operating income will be $6,000.

If we develop equations to calculate break-even and net income, we will not have to prepare an income statement to determine what net income will be at any level of sales. For example, we know that if Racing Bicycle sells 430 units, net operating income will be $6,000. The company will sell 30 units above the break-even unit sales and the contribution margin is $200 per unit, or $6,000.

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CVP Relationships in
Equation Form

The contribution format income statement can be expressed in the following equation:

Profit = (Sales – Variable expenses) – Fixed expenses

CVP relationships in equation form (for those who prefer an algebraic approach to solving problems in the chapter)

The contribution format income statement can be expressed in equation form as shown on this slide.

Variable expenses is $120,300, 401 units sold at $300 per unit.

With fixed expenses of $80,000, we can see that profit or net operating income is equal to $200. Exactly the same answer we got using the contribution income statement approach.

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CVP Relationships in
Equation Form

This equation can be used to show the profit RBC earns if it sells 401. Notice, the answer of $200 mirrors our earlier solution.

Profit = ($200,500 – Variable expenses) – Fixed

Profit = ($200,500 – $120,300) – Fixed expenses

Profit = ($200,500 – $120,300) – $80,000

$200 = ($200,500 – $120,300) – $80,000

Profit = (Sales – Variable expenses) – Fixed expenses

We begin by calculating sales.

Sales are equal to $200,500, that is, 401 units sold at $500 per unit.

Variable expenses are $120,300, 401 units sold at $300 per unit.

With fixed expenses of $80,000, we can see that profit or net operating income is equal to $200. Exactly the same answer we got using the contribution income statement approach.

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CVP Relationships in
Equation Form

When a company has only one product we can further refine this equation as shown on this slide.

Profit = (P × Q – V × Q) – Fixed expenses

Profit = (Sales – Variable expenses) – Fixed expenses

When a company has only one product we can further refine this equation as shown on this slide.

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CVP Relationships in
Equation Form

This equation can also be used to show the $200 profit RBC earns if it sells 401 bikes.

Profit = (P × Q – V × Q) – Fixed expenses

Profit = ($500 × 401 – $300 × 401) – $80,000

$200

Profit = (Sales – Variable expenses) – Fixed expenses

This equation can also be used to compute RBC’s $200 profit if it sells 401 bikes.

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CVP Relationships in
Equation Form

Unit CM = Selling price per unit – Variable expenses per unit

It is often useful to express the simple profit equation in terms of the unit contribution margin (Unit CM) as follows:

Profit = (P × Q – V × Q) – Fixed expenses

Profit = (P – V) × Q – Fixed expenses

Profit = Unit CM × Q – Fixed expenses

Unit CM = P – V

The profit equation can also be expressed in terms unit contribution margin as shown on this slide.

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CVP Relationships in
Equation Form

Profit = (P × Q – V × Q) – Fixed expenses

Profit = (P – V) × Q – Fixed expenses

Profit = Unit CM × Q – Fixed expenses

Profit = ($500 – $300) × 401 – $80,000

Profit = $200 × 401 – $80,000

Profit = $80,200 – $80,000

Profit = $200

This equation can also be used to compute RBC’s $200 profit if it sells 401 bikes. .

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End of Chapter 3

End of chapter 3.