Cost-Volume-Profit

Analysis
Chapter
22

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 Objective
1

Identify different
cost behavior patterns.

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 Types of
Costs

Variable

Fixed

Mixed

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 Variable Costs
Example
 Consider Grand Canyon Railway.
 Assume that breakfast costs Grand Canyon
Railway $3 per person.
 If the railroad carries 2,000 passengers, it
will spend $6,000 for breakfast services.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 22 -

 Variable Costs
Example

$24 –
Total Variable Costs
(thousands)

$18 –
$12 –
$6 –
–

–
–

0 1 2 3 4 5
Volume
(Thousands of passengers)
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 Fixed Costs
Example

$400 –
Total Fixed Costs
(thousands)

$300 –
$200 –
$100 –
–

–
–

0 1 2 3 4 5
Volume
(Thousands of passengers)
©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 22 -
 Mixed Costs Example

 A mixed cost is part variable and part fixed.

 Assume a department of a company has fixed
costs of $50 per month ($600 per year).
 There are also variable costs of $3 per hour.

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 Mixed Costs
Example

$2,850 –
Total Costs

$2,100 –
Variable
$1,350 – Cost

$600 – Fixed
Cost
–

–
–
–

0 125 250 375 500 625

Volume (hours)
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 Relevant Range...

– is a band of volume in which a specific

relationship exists between cost and volume.
 Outside the relevant range, the cost either
increases or decreases.
 A fixed cost is fixed only within a given
relevant range and a given time span.

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 Relevant
Range

$160,000 –
Fixed Costs

$120,000 –
Relevant Range
$80,000 –

$40,000
–

–
0 5,000 10,000 15,000 20,000 25,000
Volume in Units
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 Objective
2

Use a contribution margin

income statement to make
business decisions.

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 Two Approaches to Compute
Profits

Conventional
Conventional income
income statement
statement

Contribution
Contribution margin
margin income
income statement
statement

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 Conventional Income
Statement

Cost of Gross
Sales – =
Goods Sold Margin

Gross Operating Net

– =
Margin Expenses Income

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 Contribution
Margin
Income Statement

Variable Contribution
Sales – =
Expenses Margin

Contribution Fixed Net

– =
Margin Expenses Income

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 Contribution Margin
Example
 Luis and Tom manufacture a device that allows
users to take a closer look at icebergs from a
ship.
 The usual price for the device is $100.
 Variable costs are $70.
 They receive a proposal from a company in
Newfoundland to sell 20,000 units at a price of
$85.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 22 - 1

 Contribution Margin
Example
 There is sufficient capacity to produce the
order.
 How do we analyze this situation?
 $85 – $70 = $15 contribution margin.
 $15 × 20,000 units = $300,000 (total
increase in contribution margin)

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 22 - 1

 Objective 3

Compute breakeven sales and

perform sensitivity analyses.

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 Cost-Volume-Profit
Analysis
600
500 — Sales
400
— Fixed
$ (000)

300
200 — Fixed +
100 Variable
0
0 1 2 3 4 5
Units (000)

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 22 - 1

 Cost-Volume-Profit
Analysis
 Accountants use two methods to perform
CVP analysis.
 Both methods use an equation or formula
derived from the contribution margin
income statement. Sx – Vx – F = 0

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 Equation
Approach
With the equation approach, breakeven
sales in units is calculated as follows:

Unit
Unit sales
sales price
price ×× Units
Units sold
sold

– Variable
Variable unit
unit cost
cost ×× Units
Units sold
sold

– Fixed
Fixed expenses
expenses = Operating
Operating income
income
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 Breakeven Point
Example
 Assume that fixed expenses amount to
$90,000.
 How many devices must be sold at the
regular price of $100 to break even?
 ($100 × Units sold) – ($70 × Units sold) –
$90,000 = 0
 Units sold = $90,000 ÷ $30 = 3,000

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 22 - 2

 Contribution Margin

Per Unit Percent Ratio

Sales price $100 100 1.00
Variable expenses 70 70 .70
Contribution margin $ 30 30 .30

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 Contribution Margin
Formula

(Fixed expenses + Operating income)

÷ Contribution margin per unit = Units

($90,000 + 0) ÷ $30 = 3,000 Units

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 Contribution Margin Ratio
Formula

(Fixed expenses + Operating income)

÷ Contribution margin ratio = $ Sales

($90,000 + 0) ÷ .30 = $300,000

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 Change in Sales Price
Example
 Suppose that the sales price per device is
$106 rather than $100.
 What is the revised breakeven sales in units?
 New contribution margin: $106 – $70 = $36
 $90,000 ÷ $36 = 2,500 units

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 Change in Variable Costs
Example
 Suppose that variable expenses per device
are $75 instead of $70.
 Other factors remain unchanged.
 $90,000 ÷ $25 = 3,600
 $90,000 ÷ 0.25 = $360,000

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 22 - 2

 Change in Fixed Costs
Example
 Suppose that rental costs increased by $30,000.
 What are the new fixed costs?
 $90,000 + $30,000 = $120,000
 What is the new breakeven point?
 $120,000 ÷ $30 = 4,000 units
 $120,000 ÷ 0.30 = $400,000

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 22 - 2

 Objective
4

Compute the sales level needed to

earn a target operating income.

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 Target Operating Income
Example
 Suppose that a business would be content
with operating income of $45,000.
 Assuming $100 per unit selling price,
variable expenses of $70 per unit, and fixed
expenses of $90,000, how many units must
be sold?
 ($90,000 + $45,000) ÷ $30 = 4,500

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 Objective
5

Graph a set of cost-volume-profit

relationships.

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 Various Sales Levels
Example
 Assume selling price is $35 per unit.
 Variable expense is $21 per unit.
 Fixed cost is $7,000.
 What is the breakeven point?
 500 units or $17,500

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 Cost-Volume-Profit
Graph
$40,000
$35,000 l ine
nu e
$30,000 Breakeven sales point v e
e
500 units or $17,500 es r
$25,000 Sal e line
en s
Dollars

l ex p
$20,000 To ta
$15,000
$10,000 Fixed expense line
$5,000
$0
0 300 500 1000
Units

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 Various Sales Levels Example

 What operating income is expected when

sales are 300 units?
 $14 × 300 = $4,200

$4,200 – $7,000 = ($2,800)

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 22 - 3

 Various Sales Levels Example

 What operating income is expected when

sales are 1,000 units?
 $14 × 1,000 = $14,000

$14,000 – $7,000 = $7,000

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 Objective
6

Compute a margin of safety.

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 Margin of Safety Example

 Margin of safety is the excess of expected

sales over breakeven sales.
 Assume Luis and Tom’s breakeven point is
3,000 devices.
 Suppose they expect to sell 4,000 during the
period.
 What is the margin of safety?

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 Margin of Safety
Example

4,000 – 3,000 = 1,000 units

1,000 × $100 = $100,000

1,000 × 4,000 = 25%

$100,000 × $400,000 = 25%

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 Assumptions of CVP
Analysis
1 Expenses can be classified as either variable
or fixed.
2 CVP relationships are linear over a wide
range of production and sales.
3 Sales prices, unit variable cost, and total
fixed expenses will not vary within the
relevant range.

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 Assumptions of CVP
Analysis
4 Volume is the only cost driver.
5 The relevant range of volume is specified.
6 Inventory levels will be unchanged.
7 The sales mix remains unchanged during
the period.

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 Objective
7

Use the sales mix in CVP analysis.

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 Sales Mix
Example
 Suppose that Luis and Tom plan to sell two
types of devices instead of one.
 They estimate that sales will be 3,000
regular devices and 1,000 large devices.
 This is a 3:1 sales mix.
 They expect 3/4 of the devices sold to be
regular devices and 1/4 to be large devices.

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 Sales Mix
Example
Regular Large
Sales price $100 $154
Variable expenses 70 100
Contribution margin 30 54
Sales mix (units) 3 1
$ 90 $ 54
The total is $144.

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 Sales Mix
Example

Weighted-average
Breakeven sales
contribution margin
$90,000 ÷ $36 = 2,500
$144 ÷ (3 + 1) = $36

2,500 × 3/4 = 1,875 2,500 × 1/4 = 625

regular devices large devices

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 Sales Mix
Example

1,875 regular × $100 = $187,500

625 large × $154 = 96,250
Breakeven $283,750

$90,000 ÷ $144 = 625

packages in the mix

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 Objective
8

Compute income using variable

costing and absorption costing.

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 Product
Costing
Absorption
Absorption costing
costing assigns
assigns all
all
manufacturing
manufacturing costs
costs to
to products.
products.
Financial
Financial statements
statements prepared
prepared under
under
GAAP
GAAP useuse absorption
absorption costing.
costing.

Variable
Variable costing
costing assigns
assigns only
only variable
variable
manufacturing
manufacturing costscosts toto products.
products.
Variable
Variable costing
costing isis for
for internal
internal use
use only.
only.

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 Product Costing
Example
Assume the following costs:
Direct material unit cost $6.00
Direct labor unit cost $3.00
Variable manufacturing overhead $2.00
Variable marketing $2.50
Fixed manufacturing overhead per unit $5.00

What is the product cost/unit?

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 Product Costing
Example

Absorption
Absorption Costing
Costing

Direct materials $ 6.00

Direct labor 3.00
Variable manufacturing overhead 2.00
Fixed manufacturing overhead 5.00
Total $16.00
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 Product Costing
Example

Variable
Variable Costing
Costing

Direct materials $ 6.00

Direct labor 3.00
Variable manufacturing overhead 2.00
Fixed manufacturing overhead -0-
Total $11.00
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 End of Chapter
22

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