ACCt 230 Chapter 6 - Cost-Volume-Profit Relartionships

Contribution Margin Income Statement

Income statement that classifies costs as variable or fixed and computes contribution margin

Contribution Margin Formula

Revenues - Var. Costs. = Contribution Margin

What is the contribution margin?

The amount of sales remaining after variable expenses have been deducted

What are the 3 contribution margin formats?

1. Total Contribution Margin

2. Contribution Margin per Unit

3. Contribution Margin Ratio

Cont. Marg. per Unit formula

Unit selling price-Unit var. costs

Cont. Marg. Ratio formula

Cont. Margin per unit / Sales price per unit

OR

Total Cont. Margin / Total Sales $

Varable cost ratio formula

Total Var. Cost / Total Sales $

OR

Var. cost per unit / Sales price per unit

Traditional Income Statement Format

Sales

<COGS>

= Gross Margin

<Op. Exp.>

= Net Income

Contribution Margin Income Statement Format

Sales

<Var. Costs>

= Contribution Margin

<Fixed Costs>

= Net Income

What assumption can be made about cost behavior?

Cost can be approximated by a straight line

Equation for a cost line

Total Cost = Total VC + Total FC

OR

Total Cost = (VC per unit of activity * activity) + Total FC

Why do we have to separate mixed costs into variable and fixed?

For the cost equation

4 methods for analyzing cost behavior

1. Account Analysis

2. Scattergraph Method

3. High-Low Method

4. Least Squares/Regression Method

Account Analysis

Determine behavior based on the analyst’s prior knowledge about how costs behave-limited in value

Scattergraph method

Plot historical observations for cost and activity, then fit a line to the points so as the minimize deviations

High-Low Method

Uses formulas to calculate variable and fixed components of cost

Steps in the High-Low Method

1. Calculate VC per unit of the activity

2. Use total cost equation to solve for total fixed costs

Using the high-low method, what is the formula to solve for VC per unit of activity

High cost - Low cost

---

High activity - Low activity

Least squares/regression method

Most accurate! Uses a mathematical model to minimize deviations and determine fixed and variable costs

What is important to know when using the high-low method?

DON’T MIX HIGH AND LOW COSTS/ACTIVITY

Cost-Volume-Profit Analysis

The study of the effects of changes in costs and volume on a company’s profits

CVP considers relationships between

1. Volume/level of activity

2. Unit selling prices

3. Variable cost per unit

4. Total Fixed Costs

5. Sales Mix

Assumptions in underlying CVP analysis

1. Costs and Revenues and linear throughout relevant range

2. Costs can be classified as either variable or fixed with reasonable accuracy

3. All units produced are sold

4. Sales mix will remain constant

If sales volume increases by 10%…

• Total Sales will increase by 10%

• Total VC will increase by 10%

• Total FC will stay constant

• Total profit will increase, but not by 10%

Breakeven Point

the level of sales where the company will realize no income and suffer no loss (revenues = expenses)

Target Net Income

the profit objective for the company or an individual segment

Margin of safety

the difference between actual/expected sales and breakeven sales

Margin of safety formula

Margin of safety = Actual/expected sales - breakeven sales

What are the 3 CVP analysis equations?

1. Equation method

2. Contribution margin formula method

3. Contribution margin ratio approach

Equation method

Revenues - VC - FC = Desired profit

OR

Sales Price (x) - VC per unit (x) - Total FC = desired profit

x=Sales volume

Contribution margin formula method

x = total FC + desired profit

————————————————————--Contribution Margin per UNIT

Contribution margin ratio approach

Sales $ = Total FC + desired profit 

————————————————————--Contribution Margin RATIO

Sales Mix

The relative proportion in which each product is sold

For breakeven analysis for 2 or more products, what formula do you use?

Contribution margin ratio approach

Cost structure

relative proportion of fixed versus variable costs that the company incurs, and can have a significant effect on profitability

Operating leverage

the degree to which a company’s net income reacts to a change in sales; provides a measure of the company’s VOLATILITY

Degree of Operating Leverage formula

Degree of Op Leverage =

Total Contr. Margin

————————————————————-Net Income

The degree of operating leverage can be used to determine what?

The effect that changes in sales will have on NI

Percentage change in NOI formula

Percentage change in NOI = % change in sales * degree of operating leverage

Companies with high fixed costs relative to variable costs also have?

High operating leverage