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McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 1

Cost-Volume-Profit Analysis
(Chapter 4, Textbook)
Lecture 2
30 October 2014, LT58A
3MA_October 2014 Semester

© 2012 McGraw-Hill Education (Asia)

Learning Objectives Today…
1
...

3
...

5
...

7
...


Cost-Volume-Profit (CVP) model
Contribution margin approach
Break-even analysis
Target-profit analysis
Sensitivity analysis
Margin of safety
Operating leverage
Sales Mix & Weighted-average UCM

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 3

Key Assumptions of CVP Analysis
 Selling price is constant
...

 In multiproduct companies, the sales mix is
constant
...


McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 4

Learning Objective 1 – CVP Model

Explain how changes in
activity affect contribution
margin and net operating
income
...
The emphasis is on cost behavior
...

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 6

Basics of Cost-Volume-Profit Analysis
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Sales (500 bicycles)
$
250,000
Less: Variable expenses
150,000
Contribution margin
100,000
Less: Fixed expenses
80,000
Net operating income
$
20,000

CM is used first to cover _Fixed Expenses_
...

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 7

The Contribution Approach
Sales, variable expenses, and contribution margin can
also be expressed on a per unit basis
...

Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bicycles)
$
250,000
$
500
Less: Variable expenses
150,000
300
Contribution margin
100,000
$
200
Less: Fixed expenses
80,000
Net operating income
$
20,000

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 8

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)
...


Profit = (Sales – Variable expenses) – Fixed expenses
Quantity sold (Q)
× Selling price per unit (P)
= Sales (Q × P)

Quantity sold (Q)
× Variable expenses per unit (V)
= Variable expenses (Q × V)

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

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 10

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

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 11

Learning Objective 2 – Contribution Margin

Use the contribution margin
ratio (CM ratio) to compute
changes in contribution
margin and net operating
income resulting from
changes in sales volume
...

Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bicycles)
$ 250,000
$ 500
Less: Variable expenses
150,000
300
Contribution margin
100,000
$ 200
Less: Fixed expenses
80,000
Net operating income
$
20,000

CM Ratio
100%
60%
40%

$100,000 ÷ $250,000 = 40%
McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 13

Contribution Margin Ratio (CM Ratio)
If Racing Bicycle increases sales by $50,000, contribution
margin will increase by $20,000 ($50,000 × 40%)
...
($50,000 × 40% = $20,000)
McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 14

Pit stop #1
1
...
What’s the formula to compute CM ratio?
(Unit Selling Price-Unit variable cost)/unit selling price
Or Total CM/Total Sales revenue
3
...


McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 16

Break-even Analysis
Let’s use the RBC information to complete the breakeven analysis
...

Unit sales to
=
break even

Fixed expenses
CM per unit

$80,000
Unit sales =
$200
Unit sales = 400

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 18

Break-even in Dollar Sales:
Formula Method
Now, let’s use the formula method to
calculate the dollar sales at the break-even
point
...


McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 20

The Formula Method

The formula uses the following equation
...

Unit sales to attain
Target profit + Fixed expenses
=
the target profit
CM per unit

$100,000 + $80,000
Unit sales =
$200
Unit sales = 900

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 22

Formula Method
We can calculate the dollar sales needed to
attain a target profit (net operating profit) of
$100,000 at Racing Bicycle
...
What’s the break-even point (in dollars) formula?
Fixed Expenses/CM ratio

1
...
What’s the target profit (in units) formula?
(Target profit + Fixed Expenses)/CM per unit
4
...


McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 25

Changes in Fixed Costs and Sales Volume
Q1: What is the profit impact if Racing
Bicycle can increase unit sales from 500
to 540 by increasing the monthly
advertising budget by $10,000?

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 26

Changes in Fixed Costs and Sales Volume
$80,000 + $10,000 advertising = $90,000

Sales
Less: Variable expenses
Contribution margin
Less: Fixed expenses
Net operating income

500 units
$ 250,000
150,000
100,000
80,000
$
20,000

540 units
$ 270,000
162,000
108,000
90,000
$
18,000

Sales increased by $20,000, but net operating
income _decreased_ by $2,000
...

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 30

BREAK TIME (10min)

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 31

Learning Objective 6 – Margin of Safety

Compute the margin of
safety and explain its
significance
...

Margin of safety in dollars = Total sales - Break-even sales

Let’s look at Racing Bicycle Company
and determine the margin of safety
...

Break-even
sales
400 units
Sales
$ 200,000
Less: variable expenses
120,000
Contribution margin
80,000
Less: fixed expenses
80,000
Net operating income
$
-

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Actual sales
500 units
$ 250,000
150,000
100,000
80,000
$
20,000

Slide 34

The Margin of Safety Percentage
RBC’s margin of safety can be expressed
as 20% of sales
...


Margin of
=
Safety in units

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

$50,000
= 100 bikes
$500

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 36

Learning Objective 7 – Operating Leverage
Compute the degree of
operating leverage at a
particular level of sales and
explain how it can be used to
predict changes in net operating
income
...

It is a measure, at any given level of sales, of how a
percentage change in sales volume will affect profits
...


Sales
Less: variable expenses
Contribution margin
Less: fixed expenses
Net income

Degree of
Operating
Leverage

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Actual sales
500 Bikes
$ 250,000
150,000
100,000
80,000
$
20,000

$100,000
= $20,000

Garrison, Noreen, Brewer, Cheng & Yuen

= 5

Slide 39

Operating Leverage
With an operating leverage of 5, if RBC
increases its sales by 10%, net operating
income would increase by 50%
...


...

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 41

What does higher value of Operating
Leverage mean?


High Operating Leverage ratio




signals the existence of high fixed costs
...

increases opportunity to make profit when higher
demand exists
...


McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 43

The Concept of Sales Mix
 Sales mix is the relative proportion in which a
company’s products are sold
...

Let’s assume Curl sells surf boards and sail boards
...


McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 44

Modeling Multiple Products
Curl provides us with the following information:
Description
Surfboards
Sailboards
Total sold

Unit
Unit
Number
variable contribution
of
cost
margin
boards
500 $
300 $
200
500
1,000
400
600
300
800

Selling
price
$

Description
Sales mix
computation

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Surfboards
Sailboards
Total sold

Number
of boards
500
300
800

% of
Total
62
...
5% (300 ÷ 800)
100
...
5% $
125
...
5%
225
...
00

$200 × 62
...
We can use the sales
mix to find the number of units of each product that must be sold to
break even
...
5%
300
37
...
5% and 37
...

McGraw-Hill/Irwin
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 48



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