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### Chapter 15

Cost volume profit analysis

Cost volume profit (CVP) analysis

- Can be used to determine the effects of changes in an organisation’s sales volume on its costs, revenue and profit

The break-even point

- the volume of sales where the total revenues and expenses are equal, and the operation breaks even

Terminology

- Contribution margin (or variable costing) statement
- highlights the variable and fixed costs of a business

- Total contribution margin
- the total sales revenue minus total variable costs
- the amount available to cover fixed costs and then contribute to profits

Cont.

Terminology

- Unit contribution margin
- the difference between the sales price per unit and variable cost per unit

- Contribution margin ratio
- equal to the unit contribution margin divided by the unit sales price
- the proportion of each sales dollar available to cover fixed costs and earn a profit

Cont.

Terminology

- Contribution margin percentage
- the contribution margin ratio multiplied by 100
- the percentage of each sales dollar available to cover fixed costs and earn a profit

Cost volume profit (CVP) graph

- Shows how costs, revenue and profits change as sales volume changes
- five steps
- draw the fixed expense line
- draw the total expense line
- draw the total revenue line
- break-even point - where the total revenue and total expense lines intersect

Profit volume (PV) graph

- shows the total amount of profit or loss at different sales volumes

Target net profit

- A desired profit level determined by management
- Can be used within the break-even formula

Using CVP analysis for management decision making

- Common applications include
- safety margin
- changes in fixed expenses
- changes in the unit contribution margin
- multiple changes in key variables

Safety margin

- Difference between the budgeted sales revenue and the break-even sales revenue
- Gives a feel for how close projected operations are to the break-even point

Changes in fixed expenses

- When estimates of fixed costs are revised, the break-even point will change
- percentage change in fixed expenses will lead to similar increase in the break-even point (in units or dollars)

- Different fixed costs may apply to different levels of sales volume
- more than one break-even point

Changes in the unit contribution margin

- Change in unit variable expenses
- changes the unit contribution margin
- a new break-even point
- an increase in unit variable expenses will increase the break-even point

Cont.

Changes in the unit contribution margin

- Change in sales price
- changes the unit contribution margin
- a new break-even point
- an increase in unit price will lower the break-even point

Multiple changes in key variables

- May involve
- increasing unit prices
- undertaking an advertising campaign
- hiring a new storage facility

- An incremental approach
- focuses on the difference in the total contribution margin, fixed expenses and profits under the two alternatives

CVP analysis with multiple products

- Sales mix
- reflects the relative proportions of each type of product sold by the organisation

- Weighted average unit contribution margin
- the average of the products’ unit contribution margins, weighted by the sales mix

Assumptions underlying CVP analysis

- The behaviour of total revenue is linear
- The behaviour of total costs is linear over a relevant range
- costs can be categorised as fixed, variable or semivariable
- labour productivity, production technology and market conditions do not change
- there are no capacity changes during the period under consideration

Cont.

Assumptions underlying CVP analysis

- For both variable and fixed costs, sales volume is the only cost driver
- The sales mix remains constant over the relevant range
- In manufacturing firms, levels of inventory at the beginning and end of the period are the same

Treating CVP analysis with caution

- CVP analysis is merely a simplified model
- The usefulness of CVP analysis may be greater in less complex smaller firms
- For larger firms, CVP analysis can be valuable as a decision tool for the planning stages of new projects and ventures

Spreadsheets and computerised planning models

- Sensitivity analysis
- examines how an outcome may change due to variations in the predicted data

- Goal seeking approaches
- the analyst specifies the outcome, so that software can specify the necessary inputs

- What-if analysis
- the analyst specifies changes in assumptions to examine the effect of these changes on outcomes

An activity-based approach to CVP analysis

- ABC categorises activities as facility, product, batch or unit costs
- Facility, product and batch activities are non-volume activity costs

Limiting assumption of using activity-based costs

- Batch costs are based on likely production levels
- New planned production levels lead to changes in the number of production batches, and changes in total non-volume activity costs --> new break-even or target profit volume

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