AC331 Chapter 3 Notes
1. Understand the assumptions of cost-volume-profit (CVP) analysis
CVP analysis relies on several assumptions to simplify the complex relationship among costs, revenues, and activity levels. Key assumptions are:
; Changes in revenues and costs occur only because of changes in output.
; Total costs can be separated into fixed and variable costs.
; Revenues and costs are linearly related to output within the relevant range.
; Unit selling price, unit variable costs, and fixed costs are known and constant.
; The analysis covers only a single product or product mix.
; The analysis is not impacted by the time value of money.
2. Explain the features of CVP analysis
Features common to all CVP analysis include the following key features and terminology:
A. Revenue – Expenses = Income.
B. Contribution margin (CM) = Total Revenues (Rev) – Total Variable Costs
CM (per unit) = Unit Selling Price – Unit Variable Costs.
CM (% Sales) = Unit CM/Unit Selling Price.
CM (total) = Sales Revenues – Variable Costs
C. Multi-Step Income Statements: Rev – VC = CM – FC = OI
* FC = Fixed Costs OI = Operating Income
D. Operating Income (OI) vs. Net Income (NI)
OI + Nonoperating Income – Nonoperating Expenses – Income Tax = NI
3. Determine the breakeven point and output level needed to achieve a target operating income
Breakeven point (BEP) is the output level at which total revenues equals total costs, the point at which operating revenues is equal to zero. Total costs is the sum of total variable costs and total fixed costs, so breakeven point is the output level at which total contribution margin equals total fixed costs. But businesses are in business to make a profit, not to break even, so it is important to determine what level of activity is required to realize a specific income. Calculating the output level at which a specified target operating income (TOI) is realized requires only modifying the
basic breakeven equation to add target operating income to the fixed costs that need to be covered by contribution margin. The equations for calculating breakeven point and for calculating the output level required to earn a certain target operating income are as follows:
Breakeven Point (BEP) = Fixed Costs ? Contribution Margin
TOI Point = (Fixed Costs + TOI) ? Contribution Margin
4. Understand how income taxes affect CVP analysis
Although investors and business executives are concerned about the activity levels required to break even and to achieve certain target operating incomes, net income is another key financial measure, so it is important to understand how income taxes affect the CVP analysis. The breakeven point is not affected by income taxes because at breakeven point total revenues equals total costs so there is no operating income to be taxed. However, income taxes do affect how much of the target operating income flows to the “bottom line,” so CVP analysis commonly uses target net income (TNI) instead of target operating income as part of the analysis. The
relationship between the two is illustrated as follows:
Target Operating Income (TOI) = Target Net Income ? (1–Tax Rate)
Target Net Income Point = (Fixed Costs +TNI/ (1–Tax Rate)) ? Contribution Margin
5. Explain CVP analysis in decision making and how sensitivity analysis helps managers cope
CVP analysis is used by managers for more than just the initial determination of breakeven point or the activity level required for a specified target income. CVP analysis also helps managers in the decision-making process by allowing them to see how proposed changes in selling price and cost structure affect the breakeven point and target-income activity level. CVP analysis is used by managers as a “what-if” sensitivity-analysis tool to determine how sensitive the model is to
changes in the predicted data or if a key assumption changes. For example, what is the impact on operating income if sales are 5% less than expected, or if variable cost per unit increases by 5%?
6. Use CVP analysis to plan variable and fixed costs
The typical product cost structure includes both fixed and variable costs. A higher percentage of fixed costs in the cost structure involves more risk or operating leverage but also results in
greater operating income at higher activity levels than would a cost structure that had a higher proportion of variable costs. CVP analysis quantifies the income impact of proposed changes in the relative proportion of fixed and variable costs.
7. Apply CVP analysis to a company producing different products
Few companies produce or sell only one product. CVP analysis techniques can be utilized by managers to determine the impact of proposed changes to the current product mix. Multiplying contribution margin per product by the percentage of total sales for each product yields a single weighted-average contribution margin per unit which is then plugged into the CVP analysis to
determine breakeven point and target- income activity levels. Managers calculate the weighted-average contribution margin for each different proposed product mix and then compare the CVP analysis results for each proposed product mix to determine which product mix should be produced or sold.
8. Adapt CVP analysis to situations in which a product has more than one cost driver The CVP analysis techniques discussed in this chapter all assume that there is a single cost driver – the number of products produced or sold. In many instances there are other cost drivers that impact the variable costs per unit calculation, one of which might be the number of different customers sold to. In that instance, the variable cost per unit is a function of units sold and the
number of customers sold to. CVP techniques can be modified to analyze the impact of various multiple-cost-drivers scenarios, similar to the manner in which CVP analysis was used for product-mix decisions, but no single breakeven point or target-income activity level can be
determined because the same operating income can be achieved by different cost-driver combinations.
9. Distinguish contribution margin from gross margin
Financial income statements use the term gross margin; CVP analysis uses the term
contribution margin. Although there are similarities between the two, gross margin and contribution margin are not the same.
Gross Margin = Revenues – Cost of Goods Sold
Contribution Margin = Revenues – Variable Costs
Gross margin and contribution margin both include sales revenues in their calculation, but gross margin subtracts cost of goods sold while contribution margin subtracts variable costs. Gross
margin includes fixed product costs while contribution margin excludes fixed product costs but includes all variable costs, some of which are not product costs. Service-sector companies do not have a cost-of-goods-sold account so they can only use the contribution margin approach.