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CVP analysis

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Cost Volume Profit (CVP) Analysis.

CVP analysis

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CVP is the study of how Cost and Volume affect the profit
margin. It is a powerful tool in making managerial decisions
including marketing, production, investment, and financing
decisions.
Cost, Volume, Profit (CVP)Analysis
Prices of
products
Volume or
level of
activity
Per unit
variable
costs
Total
Fixed
Costs
Mixed of
products
sold
2
Cost Structure is the function of Fixed Cost and Variable Cost.
TC=VC+FC
Cost Structure
VC
(DM,DL, Factory
Overhead)
FC
(Factory rent,
Supervisors
Salary)
Which varies with the changes of
production “Proportionately”
Remain Fixed, doesn’t varies
with production
3
Contribution Margin is the amount remaining from sales
after variable expenses have been deducted.
Sales - Variable Expense = CM
150 – 50 = 100
CM Ratio:
CM/Sales = CMR
100/150 = 66.7%
Contribution Margin (CM)4
Formula:
BEP [Unit] = Fixed Cost / CM
BEP [Taka] = Fixed Cost / CM Ratio
Sales = Variable Cost + Fixed Cost+ Profit
Break Even Point (BEP)
BEP is the point where there is no profit no loss. (profit is Zero)
5
Selling Price=250/Unit, VC =150/Unit, FC=35,000
ABC Company is currently selling 400 speakers per month at 250 Taka per
speaker for total monthly sales of 1,00,000 Taka. Variable Expense is 150
taka/Unit. The sales manager feels that a 10,000 increase in the monthly
advertising budget would increase monthly sales by 30,000 Taka to a total of
520 Units. FC = 35,000 Taka. Should the advertising budget be increased ?
Change in Fixed Cost & Sales Volume
Particulars Current Sales New Sales Difference
Sales 100000 138000 38000
Variable Expenses 60000 90000 30000
Contribution
Margin
40000 48000 8000
Fixed Expense 35000 50000 10000
Net Operating
Income
5000 (2000) (2000)
6
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CVP analysis

  • 2. CVP is the study of how Cost and Volume affect the profit margin. It is a powerful tool in making managerial decisions including marketing, production, investment, and financing decisions. Cost, Volume, Profit (CVP)Analysis Prices of products Volume or level of activity Per unit variable costs Total Fixed Costs Mixed of products sold 2
  • 3. Cost Structure is the function of Fixed Cost and Variable Cost. TC=VC+FC Cost Structure VC (DM,DL, Factory Overhead) FC (Factory rent, Supervisors Salary) Which varies with the changes of production “Proportionately” Remain Fixed, doesn’t varies with production 3
  • 4. Contribution Margin is the amount remaining from sales after variable expenses have been deducted. Sales - Variable Expense = CM 150 – 50 = 100 CM Ratio: CM/Sales = CMR 100/150 = 66.7% Contribution Margin (CM)4
  • 5. Formula: BEP [Unit] = Fixed Cost / CM BEP [Taka] = Fixed Cost / CM Ratio Sales = Variable Cost + Fixed Cost+ Profit Break Even Point (BEP) BEP is the point where there is no profit no loss. (profit is Zero) 5
  • 6. Selling Price=250/Unit, VC =150/Unit, FC=35,000 ABC Company is currently selling 400 speakers per month at 250 Taka per speaker for total monthly sales of 1,00,000 Taka. Variable Expense is 150 taka/Unit. The sales manager feels that a 10,000 increase in the monthly advertising budget would increase monthly sales by 30,000 Taka to a total of 520 Units. FC = 35,000 Taka. Should the advertising budget be increased ? Change in Fixed Cost & Sales Volume Particulars Current Sales New Sales Difference Sales 100000 138000 38000 Variable Expenses 60000 90000 30000 Contribution Margin 40000 48000 8000 Fixed Expense 35000 50000 10000 Net Operating Income 5000 (2000) (2000) 6
  • 7. The margin of safety is the positive difference between sales and break even sales. The Margin of Safety = Sales – Break even Sales The Margin of Safety7
  • 8. Operating leverage is a measure of how sensitive net operating income is to a giver percentage change in dollar sales. DOL= CM/Net operating income Operating Leverage8
  • 9. *Oslo Company prepared the following contribution format income statement based on a sales volume of 1,000 units (the relevant range of production is 500 units to 1,500 units): Required: 1. What is the contribution margin per unit? 2. What is the contribution margin ratio? 3. What is the variable expense ratio? 4. If sales increase to 1,001 units, what would be the increase in net operating income? 5. If sales decline to 900 units, what would be the net operating income? 6. If the selling price increases by $2 per unit and the sales volume decreases by 100 units, what would be the net operating income? 7. If the variable cost per unit increases by $1, spending on advertising increases by $1,500, and unit sales increase by 250 units, what would be the net operating income? 9 Sales $20,000 Variable expenses 12,000 Contribution margin 8,000 Fixed expenses 6,000 Net operating income $ 2,000 Problem
  • 10. 8. What is the break-even point in unit sales? 9. What is the break-even point in dollar sales? 10. How many units must be sold to achieve a target profit of $5,000? 11. What is the margin of safety in dollars? What is the margin of safety percentage? 12. What is the degree of operating leverage? 13. Using the degree of operating leverage, what is the estimated percent increase in net operating income of a 5% increase in sales? 14. Assume that the amounts of the company’s total variable expenses and total fixed expenses were reversed. In other words, assume that the total variable expenses are $6,000 and the total fixed expenses are $12,000. Under this scenario and assuming that total sales remain the same, what is the degree of operating leverage? 15. Using the degree of operating leverage that you computed in the previous question, what is the estimated percent increase in net operating income of a 5% increase in sales? 10
  • 11. Solution 11 Given volume=1000 units CM per unit = CM/Volume = 8000/1000 = $8 per unit CM ratio = (CM/sales)*100 = (8000/20000)*100 = 40% Variable expenses ratio = (Variable cost/sales)*100 = (12000/20000)*100 =60% 1 2 3
  • 12. 12 CM per unit = $8 per unit Increase in unit sales (1001-1000)=1 unit Increase in Net operating income (8*1) = $8 For 900 units Particulars Amount Sales (900*20) 18000 Variable expense (900*12) 10800 CM 7200 Fixed expense 6000 Net operating income 1200 4 5
  • 13. Sales increase $2 per unit, volume decrease 100 units so, for (1000-100)=900 units 13 Particulars Amount Sales (900*22) 19800 Variable expense (900*12) 10800 CM 9000 Fixed expense 6000 Net operating income 3000 6
  • 14. Variable cost increase $1 unit increase 250 spending on advertising increases so fixed cost increases $ 1500 For (1000+250) = 1250 units. 14 Particulars Amount Sales (1250*20) 25000 Variable expense (1250*13) 16250 CM 8750 Fixed expense 7500 Net operating income 1250 7
  • 15. 15 BEP in unit = (fixed cost /CM per unit ) = (6000/8) = 750 units BEP unit sales = ( fixed cost /CM ratio ) = (6000/40%) = 150001 Given, target profit =5000 Unit sales = (fixed cost+ target profit /CM per unit) = (6000+5000/8) =1375 units 8 10 9
  • 16. 16 MOS in dollars =sales-BEP sales = 20000-15000=5000 MOS in % =( MOS/ sales)*100= (5000/20000)*100 = 25% DOL= (CM/ Net operating income) = (8000/2000) = 4 Present increase=DOL * increase =4*5=20% 11 13 12
  • 17. Given, variable expense = 6000 fixed expense =12000 17 Particulars Amount Sales 20000 Variable expense 6000 CM 14000 Fixed expense 12000 Net operating income 2000 DOL= (CM/NOI) = (14000/2000) =7 14
  • 19. Morton Company’s contribution format income statement for last month is given below: Sales (15,000 units 3 $30 per unit) . . . . . . . . . $450,000 Variable expenses . . . . . . . . . . . . . . . . . . . . . . 315,000 Contribution margin . . . . . . . . . . . . . . . . . . . . . 135,000 Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . 90,000 Net operating income . . . . . . . . . . . . . . . . . . . . $ 45,000 The industry in which Morton Company operates is quite sensitive to cyclical movements in the economy. Thus, profits vary considerably from year to year according to general economic conditions.The company has a large amount of unused capacity and is studying ways of improving profits. 19 Problem
  • 20. Required: 1.New equipment has come onto the market that would allow Morton Company to automate a portion of its operations. Variable expenses would be reduced by $9 per unit. However, fixed expenses would increase to a total of $225,000 each month. Prepare two contribution format income statements, one showing present operations and one showing how operations would appear if the new equipment is purchased. Show an Amount column, a Per Unit column, and a Percent column on each statement. Do not show percentages for the fixed expenses. 2. Refer to the income statements in (1) above. For both present operations and the proposed new operations, compute (a) the degree of operating leverage, (b) the break-even point in dollar sales, and (c) the margin of safety in both dollar and percentage terms. 20
  • 21. 3. Refer again to the data in (1) above. As a manager, what factor would be paramount in your mind in deciding whether to purchase the new equipment? (Assume that enough funds are available to make the purchase.) 4. Refer to the original data. Rather than purchase new equipment, the marketing manager argues that the company’s marketing strategy should be changed. Rather than pay sales commissions, which are currently included in variable expenses, the company would pay salespersons fixed salaries and would invest heavily in advertising. The marketing manager claims this new approach would increase unit sales by 30% without any change in selling price; the company’s new monthly fixed expenses would be $180,000; and its net operating income would increase by 20%. Compute the break-even point in dollar sales for the company under the new marketing strategy. Do you agree with the marketing manager’s proposal? 21
  • 22. Particulars Present Amount Per unit % Sales(15000 units) Variable expense 450000 315000 30 21 100 70 CM 135000 9 30 Fixed expense 90000 Net operating income 45000 22 Solution 1
  • 23. In proposed variable expense reduced$9 so, it is (21-9) = $12 and fixed expense is $225000 Particulars Present Amount Per unit % Sales(15000 units) Variable expense 450000 180000 30 12 100 40 CM 270000 18 60 Fixed expense 225000 Net operating income 45000 23
  • 24. 24 a) Degree of operating leverage : Present, DOL = (CM/NOI) = (135000/45000) = 3 Proposed, DOL= (CM/NOI) = (270000/45000) = 6 b) BEP in dollar sales Present, BEP in dollar sales = (fixed expense /CM ratio) = (90000/.3) = $300000 Proposed, BEP in dollar sales = (fixed expense /CM ratio) = (225000/0.6) = $375000 2
  • 25. 25 C) Margin of safety in dollars and % Present, MOS in dollars = actual sales –BEP sales =450000-300000 = $150000 Present, MOS %= (MOS/ actual sales)*100 = (150000/450000)*100 = 33.33% Proposed, MOS in dollars=actual sales –BEP sales =450000-375000 = $75000 Proposed, MOS %= (MOS/ actual sales)*100 = (75000/450000)*100 =16.67%
  • 26. 26 3
  • 27. 27 30% sales increase so, 450000+30% of 450000 = $585000 Fixed expense will be = $180000 NOI increase 20% = 45000+20%of 45000 = 54000 We know, Profit = (sales- Variable expense) - Fixed expense Or, 54000= (585000- Variable expense)- 180000 Variable expense=$351000 4
  • 28. Alternative way 28 We know, sales- Variable expense= CM CM - Fixed expense = NOI Let, CM=x Variable expense=y x- 180000= 54000 x= CM= 234000 then, sales –y =234000 585000-y=234000 Y= Variable expense = 351000
  • 29. Tax related Math  Taves Donuts sells donuts, coffee, and other related food items. The following information is available: Service varies from a single coffee to multiple dozen donuts. The average revenue earned for each customer is $8.00. The average cost of food and other variable costs for each customer is $3.00. Total fixed costs for the year is $450,000. The income tax rate is 30%. Target (i.e., desired) net income is $105,000. 29
  • 30. Data: SP = $8.00; VC = $3.00; FC = $450,000; Target income = $105,000; Tax Rate = .30 How many customers are needed to reach the desired profit? Solution: BE(units)= Total Fixed Cost/ CM(units) = $450,000/($8 – 3) = 90,000 customers 30
  • 31. Desired customers,Q= (FC + Desired Profit)/ CM(units) As we know, Revenue – Cost of goods sold = Gross Margin Gross Margin – Other Expense = Net Income Before Tax Net Income Before Tax – Income Tax = Net Income So, NIBT – (NIBT* tax rate) = NI NIBT (1 – tax rate) = NI NIBT = NI/ (1 – tax rate) = $105,000/ (1 – .30) = $150,000 31
  • 32. so, Desired Customers,Q = (450,000+150,000)/($8 – 3) =120,000 customers (Answer) 32
  • 33. CVP for Multi-Product Company 33
  • 34. Particulars Velcro Metal Nylon Normal annual sales volume 100,000 200,000 400,000 Unit selling price $1.65 $1.50 $0.85 Variable expense per unit $1.25 $0.70 $0.25 Total fixed expenses are $400,000 per year. All three products are sold in highly competitive markets, so the Walmart company is unable to raise its prices without losing unacceptable numbers of customers. The company has an extremely effective lean production system, so there are no beginning or ending work in process or finished goods inventories CVP for Multi-Product Company
  • 35. Required: 1. What is the company’s over-all break-even point in dollar sales? 2. Of the total fixed expenses of $400,000, $20,000 could be avoided if the Velcro product is dropped, $80,000 if the Metal product is dropped, and $60,000 if the Nylon product is dropped. The remaining fixed expenses of $240,000 consist of common fixed expenses such as administrative salaries and rent on the factory building that could be avoided only by going out of business entirely. a. What is the break-even point in unit sales for each product? b . If the company sells exactly the break-even quantity of each product, what will be the overall profit of the company? Explain this result.
  • 36. Particular Velcro Metal Nylon Total Sales $165,000 $300,000 $340,000 $805,000 Variable expenses 125,000 140,000 100,000 365,000 Contribution margin $40,000 $160,000 $240,000 440,000 Fixed expenses 400,000 Net operating income 40,000 Solution 1.
  • 37. Continued.. 2. The issue is what to do with the common fixed cost when computing the break-evens for the individual products. The correct approach is to ignore the common fixed costs. If the common fixed costs are included in the computations, the break-even points will be overstated for individual products and managers may drop products that in fact are profitable. a. The break-even points for each product can be computed using the contribution margin approach as follows:
  • 38. b. If the company were to sell exactly the break-even quantities computed above, the company would lose $240,000—the amount of the common fixed cost. This can be verified as follows: Continued..