Cost-Volume-Profit Analysis

Chapter 3: Cost-Volume-Profit Analysis

Introduction

  • Cost-Volume-Profit (CVP) Analysis aids managers in understanding the relationship between costs, volume, and profit.

  • Important concepts include how operating income changes with changes in output level, selling prices, variable costs, or fixed costs.

Real-World Example: Coachella Music Festival

  • Overview: Annual music festival featuring over 150 major musical acts.

  • Costs:

    • Headlining acts (e.g., Beyoncé) can charge up to $4 million.

    • Production costs (stagehands, insurance, security) can reach $12 million before the first performance.

  • Revenue Strategy:

    • To cover high fixed costs and realize a profit, Coachella regularly sells tickets, expanding its strategy to include two festivals on consecutive weekends and an additional country music festival, Stagecoach.

    • Tickets prices range from $429 to $9,500, resulting in $114 million in ticket sales for Coachella and $22 million for Stagecoach in 2017.

High Fixed Cost Businesses

  • Examples include American Airlines and General Motors which pay more attention to decision-making due to their need for significant revenues to break even.

  • In airlines, profits are usually tied to the last few passengers boarding each flight.

  • Discussed is the bankruptcy declaration by American Airlines due to a drop in revenues.

Key Assumptions of CVP Analysis

  • The selling price remains constant.

  • Costs are linear and can be divided into fixed and variable elements:

    • Variable costs: Constant per unit.

    • Fixed costs: Constant in total.

  • In a multiproduct context, the sales mix remains constant.

  • For manufacturing, it’s assumed that inventories do not change (units produced = units sold).

Essentials of CVP Analysis

  • Examines how operating income is influenced by various factors:

    • Changes in output levels

    • Selling prices

    • Variable costs

    • Fixed costs

Contribution Margin (CM) Basics

  • Definition: CM is the amount leftover from sales after variable expenses are deducted.

  • The contribution income statement assists managers in evaluating the profit impact of modifications in selling price, costs, or volume, emphasizing cost behavior.

  • The contribution margin first covers fixed expenses and any surplus contributes to net operating income.

Contribution Approach Example

  • Sales per package: $200

  • Variable costs per package: $120

  • Contribution margin per package: $80

  • Fixed costs: $2,000

  • Operating Income for various packages:

    • 0 packages: $(2,000)

    • 10 packages:

    • Revenue: $2,000

    • Variable Costs: $1,200

    • Operating Income: $(200)

    • 25 packages: Revenue: $5,000, Operating Income: $1,200

  • For achieving break-even:

    • The contribution margin equation: $0 = Q($200) - $80,000, solved gives: Q = 400 Bikes.

Break-even Analysis Methods

  • Unit Sales: Equation Method:

    • $0 = Q($200) - $80,000 => $80,000 = $200Q => Q = 400 Bikes

  • Dollar Sales: Equation Method:

    • To compute required sales for break-even:

    • NOI = CM Ratio × Sales - Fixed Expenses

    • Set NOI to zero, find Sales that results in no profit.

  • Formula Method for break-even point:

    • Unit sales required = Fixed expenses / Contribution margin per unit = 400

Target Profit Analysis

  • The number of units to sell for a given target profit can be determined by two methods:

    1. Equation Method:

    • NOI = Q(Unit CM) - Fixed Expenses

    1. Formula Method:


    • Target Profit + Fixed Expenses / CM per unit = Unit sales required

Income Taxes and Target Net Income

  • Net Income:

    • NI = NOI - (NOI x Tax Rate)

    • Rearranged to find NOI when NI is known: NOI = Net Income / (1 - Tax Rate)

  • Example Calculation:

    • Given NOI = $100,000 and tax rate = 30%:

    • NI = $100,000 - ($100,000 x 0.3) = $70,000

  • Finding Units Sold for Target NI:

    • Target NOI = Target NI / (1 - Tax Rate) = $960 / (1 - 0.4)

    • Then compute number of units based on the desired profit.

Sensitivity Analysis

  • Exploring the changes in fixed costs and sales volumes.

  • For Racing Bicycle Company (RBC), an increased advertising spend can lead to increased sales but potentially decreased operating income.

Changes in Pricing and Cost Structures

  • Adjustments in selling prices can contribute to increased operating income.

  • Structuring cost (variable vs fixed) is critical in determining profits.

Margin of Safety

  • Definition: The margin of safety is calculated as:

    • Margin of Safety (dollars) = Total Sales - Break-even Sales.

  • Expressed in units as well for clarity, critical for assessing risk.

Operating Leverage

  • Definition: Operating Leverage measures how sensitive net operating income is to sales changes. Calculation:

    • Operating Leverage = Contribution Margin / Net Operating Income

  • Illustrates that if sales increase, net income rises significantly based on leverage.

Multiple Products CVP Analysis

  • When managing multiple products, sales mix affects break-even points and profitability.

  • Employ weighted averages when considering contribution margins across various products.

Application in Service or Non-Profit Organizations

  • Deciding on appropriate output measures for different industries (e.g., airlines, hospitals, universities) is critical for applying CVP effectively.