The McGraw-Hill Companies, Inc. 2008 McGraw-Hill/Irwin CHAPTER 5 Cost-Volume- Profit Relationships
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The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin
CHAPTER 5
Cost-Volume-Profit
Relationships
The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin
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Tickets sold 2,700 3,000 3,300
Revenue ($18 per ticket) 48,600$ 54,000$ 59,400$
Cost of Band ($16 per ticket sold) 43,200 48,000 52,800
Gross Profit 5,400$ 6,000$ 6,600$
Operating Leverage
10% RevenueIncrease
10% GrossProfit Increase
The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin
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Operating Leverage
Tickets sold 2,700 3,000 3,300
Revenue ($18 per ticket) 48,600$ 54,000$ 59,400$
Cost of Band (Fixed) 48,000 48,000 48,000
Gross Profit 600$ 6,000$ 11,400$
10% RevenueIncrease
90% GrossProfit Increase
The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin
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Lessons Learned
When all costs are variable, the potential for profits is limited,
because costs keep growing with volume.
When all costs are variable, the potential for profits is limited,
because costs keep growing with volume.
When all costs are fixed, after the fixed costs are covered, every
additional sales dollar contributes the whole dollar to gross profit. The
profit potential is higher.
When all costs are fixed, after the fixed costs are covered, every
additional sales dollar contributes the whole dollar to gross profit. The
profit potential is higher.
The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin
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Operating Leverage A measure of the extent to which fixed costs are
being used in an organization to change profit.
Operating leverage is greater in companies that have a high proportion of fixed costs in
relation to variable costs.
A measure of the extent to which fixed costs are being used in an organization to change profit.
Operating leverage is greater in companies that have a high proportion of fixed costs in
relation to variable costs.
Fixed Costs
Smallpercentagechange inrevenue
Largepercentagechange in
profits
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Contribution margin
Net income
Operating
Leverage=
Show mean example.
Measuring Operating Leverage Using Contribution Margin
The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin
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Actual sales 5,000
HammersSales 50,000$ Less: variable expenses 30,000 Contribution margin 20,000 Less: fixed expenses 15,000 Net income 5,000$
$20,000
$5,000
Operating
Leverage= = 4
Measuring Operating Leverage Using Contribution Margin
A 10% increase in sales will result in a 40% increase (10% × 4) in net income.
The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin
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Operating Leverage
Curent sales 5,000 Hammers
Increased sales 5,500 Hammers
Sales 50,000$ 55,000$ Less: variable expenses 30,000 33,000 Contribution margin 20,000 22,000 Less: fixed expenses 15,000 15,000 Net income 5,000$ 7,000$
10% SalesIncrease
40% Profit Increase
Verify: ($7,000 - $5,000) / $5,000 = 40 %
The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin
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Level of Fixed Cost
Operating Leverage
Earnings Volatility & Risk
High High High
Low Low Low
Effect of Cost Structure on Profit Stability
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If the number of units sold increases by 10% for all three companies, which company will enjoy the highest net income?
Effect of Cost Structure on Profit Stability
Is it true that If the number of units sold decreases by 15% for all three companies, All Variable Company will have higher net income than All Fixed Company?
Units Sold 10 10 10
Selling Price Per Unit 10$ 10$ 10$
Variable Cost Per Unit 0 3 6
Sales Revenue 100$ 100$ 100$
Total Variable Cost 0 (30) (60)
Contribution Margin 100$ 70$ 40$
Total Fixed Cost (60) (30) 0
Net Income 40$ 40$ 40$
All Fixed Company
Combination Company
All Variable Company
The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin
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Cost-Volume-Profit (CVP) Analysis
CVP analysis summarizes the relationship between an organization’s volume of activity and its costs, revenue and profit within the relevant range.
The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin
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CVP AnalysisWhen running any business – • The first concern is if it can sell
enough to cover all its costs (Breakeven analysis).
• The second concern is whether it can reach a desired profit (Target profit analysis).
• The third concern is how to assess and select different strategies (CVP impact analysis)
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Determining the Break-even Point
•The break-even point is the point where total revenue equals to total costs (both variable and fixed), and therefore the profit is zero.
•The break-even point is the point where total revenue equals to total costs (both variable and fixed), and therefore the profit is zero.
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Cost-Volume-Profit Graph
Revenue
Total Cost
Fixed Cost
Units Sold
Do
llars
Break-even Point
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The Equation Method
We can use the profit equation to find out the BE point
in units.
At the break-even point:
Total Sales – Total Costs = Zero
Total Sales - Total Variable costs - Total Fixed Costs =
Zero
where:
Total Sales = Selling price per unit * BE Units
Total Variable Costs = Variable cost per unit * BE Units
We can use the profit equation to find out the BE point
in units.
At the break-even point:
Total Sales – Total Costs = Zero
Total Sales - Total Variable costs - Total Fixed Costs =
Zero
where:
Total Sales = Selling price per unit * BE Units
Total Variable Costs = Variable cost per unit * BE Units
The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin
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Reaching a Target Profit Level
If we want to consider the desired profit, the profit equation would be:
Total Sales – Total Costs = Desired Profit
Total Sales - Total Variable Costs - Total Fixed
costs = Desired profit
Total Sales – Total Costs = Desired Profit
Total Sales - Total Variable Costs - Total Fixed
costs = Desired profit
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Determining the Break-even Point Using a Formula
Break-evenvolume in units=
Fixed costsContribution margin per
unit
By re-arranging the Profit Equation at break-even, we can derive a formula to quickly compute Break-even Point in
Units.Break-even
volume in units=Fixed costs
(Unit Selling Price – Unit Variable Cost)
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Reaching a Target Profit Using the Formula
The formula can be expanded to include a target profit analysis.
Sales volumein units
=Fixed costs + Desired profit
(Unit Selling Price – Unit Variable Cost)
Sales volumein units
=Fixed costs + Desired profit
Contribution margin per unit
The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin
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CVP AnalysisWhat do you think “units” mean
in giant retailers, such as Wal Mart?
Can Wal Mart do a Break-even analysis?
Can it figure out the level of Sales to reach its desired profit?
The answers to both are YES!It uses Contribution Margin Ratio!
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Contribution Margin Ratio
Contribution Margin (CM) Ratio
= Total CM Total sales
= Unit CM Unit selling price
The contribution margin ratio (CM%) measures the percentage of sales that is
contribution margin.
For example, a 25% CM ratio means for every
$100 of sales, $25 (25% of $100) is CM, and $75
(75% of $100) is variable cost.
The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin
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Contribution Margin Ratio
Break-even in Sales DollarsBreak-even in Sales Dollars
Fixed costs
CM ratio=
By re-arranging the Profit Equation at break-even, we can derive a formula to quickly compute Break-even in Sales Dollars, using CM ratio.
The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin
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Contribution Margin Ratio
Sales Dollars to reach a desired profit
Sales Dollars to reach a desired profit
Fixed costs + Desired profitCM ratio=
The formula with CM ratio can be further expanded to include a target
profit analysis.
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Contribution Margin Ratio• Consider the following Income Statement:
What is the Break-even Sales?What is the Total Sales if the target profit is $60,000?What is the total Variable Cost at Break-even point?
Sales $100,000
- Variable Costs $40,000
Contribution Margin $60,000
- Fixed Costs $30,000
Net Income $30,000
CM%=$60,000/$100,000=60%
BE$ = TFC / CM% = $30,000 / 60% = $50,000Sales for $60,000 profit = ($30,000+$60,000)/60% = $150,000 Total variable cost at BE = BE sales * (1 – CM%) = $50,000 * 40% = $20,000
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CVP Impact Analysis
1.To examine the profit impact of changes in fixed costs, variable costs, selling price, and the mix of products.
2.To find out the allowable selling price, fixed costs, or variable costs, given a target level of profit.
3.Examples:
The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin
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BE and Target Profit Analysis
Equation Method:Total Sales - Total Variable costs - Total Fixed costs = Desired profit
Equation Method:Total Sales - Total Variable costs - Total Fixed costs = Desired profit
Sales volumein units
=Fixed costs + Desired
profit Contribution margin per unit
CM per unit Formula Method:
CM % Formula Method:
Sales Dollars
=Fixed costs + Desired
profit Contribution margin %
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