cost-volume-profit

cost-volume-profit (CVP) analysis

one of the most powerful tools that managers have at their disposal, helps managers understand the relationships among cost, volume, and profit by focusing on interactions among the following elements:

1. prices of products

2. volume or level or activity

3. per unit variable costs

4. total fixed costs

decisions made in CVP analysis

1. deciding what products and services to offer

2. determining what pricing policy to follow

3. choosing a marketing strategy to employ

4. deciding what basic cost structure to use

4 basic elements of a CVP analysis

1. break-even calculations

2. target profit analysis

3. margin of safety

4. operating leverage

contribution margin

represents the amount of revenue that is available to:

1. pay (cover) fixed costs

2. contribute toward a profit

3 ways to express contribution margin

1. total contribution margin = sales revenue - variable costs

2. contribution margin per unit - selling price per unit - variable costs per unit

3. contribution margin ratio (percentage of sales) = CM / SR or CM per unit / SP per unit

break-even point

point where no profit is earned (or loss incurred)

• in units, represents number of units that must be sold to ‘break even’

• in sales dollars, represents amounts of sales revenue that must be generated to ‘break even’

break-even point formula

sales = variable costs + fixed costs

margin of safety

a measure of firm riskiness, measures the amount of sales can fall before losses occur

• higher the margin of safety, lower the risk of reporting losses

margin of safety formula

actual sales revenue - break even sales revenue

operating leverage

a measure of how sensitive net income is to percentage changes in sales

• the degree of operating leverage is a measure, at a given level of sales, of how a percentage change in sales volume will impact net income

• the degree of operating leverage tells us the percentage change in net income for every 1% change in sales

operating leverage formula

degree of operating leverage = contribution margin / net income

sales mix

the relative combination of products being sold by a firm

package contribution margin per unit

allows us to convert a multiple-product problem into a single-product CVP format