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    CVP Slides

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    CVP Slides

    Uploaded by

    Ayandiswa Ndebele

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    © All Rights Reserved
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    You are on page 1of 42

    COST-VOLUME-PROFIT

    RELATIONSHIPS
    Chapter 4

    Chapter 11: Strategic Leadership


    Brief outline

    1. Learning objectives
    2. Introduction
    3. Accountant’s and economist’s models
    4. Break-even analysis
    5. Sensitivity analysis
    6. Break-even analysis with multiple
    products
    7. CVP analysis assumptions and
    limitations
    8. Link to other chapters
    1 Learning objectives

    Discuss the purpose and usefulness of CVP analysis

    Explain how changes in activity levels, variable costs, fixed costs and selling
    price impact on an organisation’s contribution margin and profit

    Understand the differences between the economist’s and accountant’s models of


    CVP analysis

    Calculate the break-even point using net profit formula, contribution margin
    formula or break-even chart

    Apply CVP analysis to ‘what-if’ scenarios

    Apply CVP analysis to multiple products/services and explain the impact of


    changes in sales mix on contribution margin and profit

    Explain the limitations of CVP analysis


    2 Introduction

    Cost-volume-
    Impact of cost profit (CVP)
    behaviour, analysis
    production levels considers the CVP is a useful
    and sales interrelationship short-term
    volumes on between activity planning tool
    organisations’ levels, costs and
    profit an organisation’s
    profit
    3 Accountant’s and economist’s
    models

    Economist’s model
    • Recognises that the rate of change in
    total costs and total revenues is unlikely
    to remain constant as volumes change
    Accountant’s model
    • Assumes a constant rate of change in
    total costs and total revenues with
    volume changes (linear relationship)
    3.1 Economists’ model

    Total cost changes:

    Excess of
    Up to optimum
    Low production optimum
    production level:
    levels: steeper production level:
    flatter cost rises
    cost rises due to steeper cost rises
    due to efficiencies
    inefficiencies (no due to
    (previously
    economies of bottlenecks/break-
    unutilised
    scale) downs/managing
    capacity)
    complexity
    3.1 Economists’ model (continued)
    3.2 Accountants’ model

    Selling price per unit, variable cost per unit and total
    fixed cost remain constant

    Linear relationship between levels of activity, total


    revenue and total cost
    3.2 Accountants’ model (continued)
    3.2 Accountants’ model (continued)

    Advantage: simple and easy to apply

    Disadvantage: does not provide accurate results across all


    possible activity ranges, because in reality fixed costs increase
    stepwise and sales volume varies with selling price changes

    Consider results only in relevant range to utilise advantage and


    obtain accurate results

    • Relevant range is the range of activity over which cost and


    revenue behaviour assumptions remain valid
    3.2 Accountants’ model (continued)
    3.2 Accountants’ model (continued)

    Variable costing approach should be


    applied for CVP analysis
    • CVP analysis is a decision-making tool
    • Fixed costs are mostly irrelevant in short-term
    decision-making and should therefore be
    ignored
    • VC approach treats fixed costs as period costs,
    therefore break-even point is not additionally
    affected by differences between production and
    sales levels (only one break-even point exists)
    4 Break-even analysis
    Most common
    application of CVP
    analysis
    Variable costing splits
    fixed and variable cost
    element
    CVP analysis assumes
    volume is the only
    revenue and cost driver

    Break-even point is • Neither profit nor loss is made


    the level of activity • Total sales equal total costs
    where

    • Profit formula
    Methods to compute • Contribution margin formula
    break-even point:
    • Break-even chart
    4.1 Profit formula

    P = SPx – (FC + VCx)


    • P = profit
    • SP = selling price per unit
    • x = number of units sold
    • FC = total fixed costs per
    annum
    • VC = variable costs per unit
    4.1 Profit formula (continued)
    4.1 Profit formula (continued)

    Solution:
    Profit should be 0
    0 = 2 500x – (750 000 + 1 000x)
    1 500x = 750 000
    x = 500
    4.2 Contribution margin formula

    Contribution = selling price – variable cost

    Contribution margin ratio = contribution / selling price

    Break-even point occurs when total contribution equals


    total fixed cost

    Break-even units = total fixed costs / contribution per


    unit

    Break-even sales revenue = total fixed costs /


    contribution margin ratio
    4.2 Contribution margin formula
    (continued)
    4.2 Contribution margin formula
    (continued)
    Solution:
    Contribution margin ratio = R1 500 / R2 500 = 0,6

    Break-even sales value = R750 000 / 0,6 = R1 250 000

    Break-even point = R750 000 / R1 500 = 500

    Break-even sales value = 500 x R2 500 = R1 250 000


    4.3 Break-even chart
    Depicts break-even point graphically

    Least accurate method


    5 Sensitivity analysis

    Sensitivity analysis indicates how sensitive one variable is to


    changes in another variable in the same model

    ‘What-if’ analysis

    • Consider alternative courses of action


    Allows • Make more informed decisions
    managers • Recognise that all decisions are subject to a degree of
    to: uncertainty and risk

    • Amount of profit given level of activity


    Common • Target profits
    forms of • Margin of safety
    sensitivity • Additional sales volume required to cover additional costs
    analysis: • Reduction on selling price to increase sales volume
    5.1 Amount of profit given level
    of activity

    The profit for any given level Easiest to use profit


    of activity within the relevant formula:
    range can be computed, • P = SPx – (FC + VCx)
    given the selling price,
    variable costs and fixed cost
    5.2 Target profits

    Then, given the


    Use one of
    other variable, the following
    Firstly,
    compute the formulae, to
    determine
    unit sales level solve for the
    target profit or the selling unknown
    price required variable:
    to reach the
    target
    • Profit formula
    • Contribution
    margin formula
    5.2 Target profits (continued)
    5.2 Target profits (continued)

    Solution 1: using the profit formula P = SPx – (FC + VCx)

    150 000 = 2 500 – (750 000 + 1 000)


    150 000 = 2 500 – 750 000 - 1 000
    1 500 = 900 000
    = 600

    Therefore 600 lawnmowers need to be sold to make a


    target profit of R150 000
    5.2 Target profits (continued)

    Solution 2: using the profit formula P = SPx – (FC + VCx)

    450 000 = SP x 750 – (750 000 + 1 000 x 750)


    450 000 = 750SP – 750 000 - 750 000
    750SP = 1 950 000
    SP = 2 600

    Therefore a selling price of R2 600 per lawnmower will


    need to be set
    5.3 Margin of safety
    Margin of safety is a measure of the extent to which the current
    (or expected) level of sales can drop before a loss is incurred

    Difference between expected sales and break-even sales

    Shown as %, total sales value or number of units

    Margin of safety(%) = current sales – break-even sales x 100


    current sales

    Margin of safety (units) = current sales volume – break-even sales


    volume

    Margin of safety (sales value) = current sales – break even sales


    OR
    = margin of safety units x SP p/u
    5.3 Margin of safety (continued)
    5.3 Margin of safety (continued)

    Solution:
    Margin of safety % = current sales – break-even sales x 100
    current sales
    = 750 – 500 x 100
    750
    = 33,3%
    5.4 Additional sales volume to
    cover additional costs
    Computed to
    determine whether
    the increased costs
    are warranted

    Using one of the


    following formulae, • Profit formula
    (only use the
    additional fixed
    • Contribution
    cost) and then margin formula
    solve for
    5.4 Additional sales volume to
    cover additional costs (continued)
    5.4 Additional sales volume to
    cover additional costs (continued)

    Solution (profit formula):


    0 = 2 500x – (60 000 + 1 000x)
    0 = 2 500x – 60 000 - 1 000x
    1500x = 60 000
    x = 40
    5.5 Reduction in selling price to
    increase sales volume
    To determine whether the increase in
    sales volume is sufficient to offset the
    loss in sales revenue from the selling
    price decrease

    Aim is to obtain the selling price that


    results in the greatest total contribution

    Use one of the following • Profit formula


    formulae to solve for the • Contribution margin formula
    profit under the different
    scenarios
    5.5 Reduction in selling price to
    increase sales volume (continued)
    5.5 Reduction in selling price to
    increase sales volume (continued)
    Solution (contribution margin formula):

    Fixed cost is constant in both cases and can therefore be


    ignored

    Total contribution = number of units x contribution per unit

    Currently total contribution: = 750 x (2 500 – 1 000)


    = 1 125 000
    New total contribution: = 850 x (2 250 – 1 000)
    = 1 062 500

    Decreasing the selling price would decrease total contribution


    (and therefore profit) by R62 500 and therefore should not be
    implemented.
    6 Break-even analysis with
    multiple products
    Each product has own break-even point as selling price and
    cost structure differ

    Common fixed costs are fixed costs that are not directly
    attributable to products

    Ways to deal with common fixed costs


    • Allocate FC to products
    • Arbitrary, therefore distorts decision-making
    • Ignore FC
    • May not be recovered, which is not sustainable in long term
    • Conduct break-even analysis with sales mix and weighted-average unit
    margin contribution
    • Most commonly-used method
    6.1 Sales mix and weighted-
    average contribution margin

    Sales mix is the proportion in which an organisation’s


    products/services are sold/delivered

    Compute weighted-average unit contribution margin


    and then apply the contribution margin formula
    • FC = individual FC + common FC

    Break-even point changes with sales mix variations

    • Accurate sales mix prediction is vital


    6.1 Sales mix and weighted-average
    contribution margin (continued)
    6.1 Sales mix and weighted-average
    contribution margin (continued)
    Solution:
    Break-even units = total FC / weighted average contribution margin
    = (15 000 + 810 000) / [(3 x 1 150) + (2 x 1 500) + (1 x 150)]
    = 750 units

    Break-even point for each individual product:


    • Product A: 750 x 3 / (3 + 2 + 1) = 375
    • Product B: 750 x 2 / 6 = 250
    • Product C: 750 x 1/6 = 125
    7 CVP analysis assumptions
    and limitations

    A number of assumptions
    They are crucial in
    and limitations underlie
    performing a valid and
    CVP analysis (refer pages
    reliable CVP analysis
    94 -96 of the textbook)
    8 Link to other chapters
    Cost behaviour
    classification to apply
    CVP analysis
    • Chapter 2: Cost classification

    Often fixed costs are Usage of variable costing


    irrelevant for short-term system is assumption
    decision-making • Chapter 5: Absorption versus
    • Chapter 10: Relevant costs for variable costing
    decision-making

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