Week 10 - Cost Volume Profit Analysis

Week 10 Lecture: Cost Volume Profit (CVP) Analysis

Cost Behavior

  • Costs react differently to changes in business activity.
Variable Costs
  • Vary in total directly and proportionately with changes in activity level.
  • Total variable costs increase with more units produced.
  • Variable cost per unit remains constant.
  • Example: Steering wheels for cars at 100100 per unit.
Fixed Costs
  • Remain relatively constant regardless of activity level.
  • Fixed cost per unit decreases as activity level increases.
  • Total fixed costs remain constant.
  • Example: Factory rent at 10,00010,000 per month.
Cost Behavior in Graphs
  • Total variable costs increase as units produced increase.
  • Variable cost per unit stays the same.
  • Total fixed costs remain constant regardless of units produced.
  • Fixed cost per unit decreases as production volume increases.
Lecture Example 1: Classifying Costs
  • Rubber used by Dunlop: Variable, Product (Direct Materials)
  • Sales commission: Variable, Period
  • CEO salary: Fixed (base salary) + Variable (bonus), Period
  • Ink for Sydney Morning Herald: Variable, Product (Direct Materials)
  • Insurance on manufacturing equipment: Fixed, Product

Cost Volume Profit (CVP) Analysis

  • Helps businesses improve profitability by focusing on costs and sales volume.
Purpose of CVP Analysis
  • Determine breakeven point.
  • Understand the impact of cost changes on sales volume and profit.
  • Determine sales level needed to make a profit.
  • Assess the impact of selling price changes on sales volume and profitability.
Basic Assumptions of CVP Analysis
  • Costs and revenues are linear within a specific range.
  • All costs are identifiable as either variable or fixed.
  • Costs are affected only by changes in activity level.
  • All units produced are sold.
Key Relationships in CVP Analysis
  • Contribution Margin
  • Breakeven Point
  • Margin of Safety
  • Target Profit

Contribution Margin

  • Sales revenue remaining after deducting variable costs.
  • Formula: Sales Revenue - Variable Costs
  • Amount available to cover fixed costs and generate profit.
Contribution Margin Calculations
  • Total Contribution Margin: Total Sales Revenue - Total Variable Costs
  • Contribution Margin per Unit: Unit Selling Price - Unit Variable Cost
Lecture Example 2: Trafford Limited
  • Selling price: 200200 per heater
  • Direct materials: 3535 per unit
  • Direct labor: 1.5 hours at 2020 per hour = 3030 per unit
  • Manufacturing overhead: 3333 per unit
  • Contribution Margin per Unit: 200 - (35 + 30 + 33) = $102
Contribution Margin Ratio

  • Contribution Margin per Unit / Unit Selling Price expressed as a percentage.

  • For Trafford Limited 102/200=51102/200 = 51%

  • Indicates the proportion of each sales dollar available to cover fixed costs and contribute to profit.

Breakeven Point

  • Level of activity resulting in zero profit (Total Revenues = Total Expenses).
Breakeven Point Calculations
  • In Sales Units: Fixed Costs / Contribution Margin per Unit
  • In Sales Dollars: Fixed Costs / Contribution Margin Ratio
Lecture Example 3: Edward Limited
  • Selling price: 4040 per book
  • Fixed costs: 440,000440,000
  • Variable costs: 1818 per unit
  • Contribution Margin Ratio: Contribution Margin per unit (40-$18=22) / Selling Price per unit (40)=5540) = 55
  • Breakeven Point in Sales Units: 440,000 / $22 = 20,000 units
  • Breakeven Point in Sales Dollars: 440,000 / 0.55 = $800,000

Margin of Safety

  • Excess of actual or expected sales above the breakeven point.
  • Measures how much sales can drop before a loss occurs.
Margin of Safety Calculations
  • Margin of safety in dollars: Actual Sales - Breakeven Sales
  • Margin of safety percentage: (Margin of safety in dollars/ Actual Sales) * 100
Lecture Example 4: Edward Limited Continued
  • Actual Sales: 1,000,0001,000,000
  • Breakeven Sales: 800,000800,000
  • Margin of Safety in Dollars: 1,000,000 - $800,000 = $200,000
  • Margin of Safety Percentage: 200,000/$1,000,000= 20
  • Sales could drop by 20% before a loss occurs.

Target Profit

  • Profit goal set by management for each product line.
  • Shows the level of sales necessary to achieve a specific profit.
Target Profit Calculation
  • Required Sales in Dollars = (Fixed Costs + Target Profit) / Contribution Margin Ratio
Lecture Example 5: Edward Limited Continued
  • Target Profit: 330,000330,000
  • Contribution Margin Ratio: 5555
  • Required Sales in Dollars: (440,000 + $330,000) / 0.55 = $1,400,000
  • Useful for motivating sales staff.