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Chapter 3

chapter 3 notes

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Department
Accounting
Course
ACC 410
Professor
Maurizio Di Maio
Semester
Summer

Description
Chapter 3 Chapter Overview Cost–volume-profit (CVP) analysis helps managers •understand the interrelationships among cost, volume, and profit by focusing their attention on the interactions among the process of products, volume of activity, per unit variable costs, total fixed costs, and mix of products sold. •choose the most favourable combination of variable costs, fixed costs, selling price, sales volume, and mix of products sold. Various concepts will be covered such as the unit contribution margin, the break-even point, the CM ratio, margin of safety, operating leverage, and the sales mix. A. The Basics of Cost-Volume-Profit (CVP) Analysis. Cost-volume-profit (CVP) analysis is a key step in many decisions. CVP analysis involves specifying a model of the relations among the prices of products, the volume or level of activity, the unit variable costs, the total fixed costs, and the mix of products sold. This model is used to predict the impact on profits of changes in those parameters. 1. Contribution Margin. Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. It contributes towards covering fixed costs and then towards profit. 2. Unit Contribution Margin. When there is a single product, the unit contribution margin can be used to predict changes in the contribution margin and in profits (assuming there is no change in fixed costs) as a result of changes in unit sales. To do this, the unit contribution margin is simply multiplied by the change in unit sales. 3.Contribution Margin Ratio. The contribution margin (CM) ratio is the ratio of the contribution margin to total sales. It shows how the contribution margin is affected by a given dollar change in total sales. Managers often find the contribution margin ratio easier to work with than the unit contribution margin, particularly when a company has multiple products. This is because the contribution margin ratio is denominated in sales dollars, which is a convenient way to express activity in multi-product firms. B. Some Applications of CVP Concepts. CVP analysis is typically used to estimate the impact on profits of changes in selling price, variable cost per unit, sales volume, and total fixed costs. CVP analysis can be used to estimate the effect on profits of a change in any one (or any combination) of these parameters. A variety of examples of applications of CVP are provided in the text. C. CVP Relationships in Graphic Form. Graphs of CVP relationships can be used to gain insight into the behaviour of expenses and profits. The basic CVP graph is drawn with dollars on the vertical axis and volume in units on the horizontal axis. Total fixed expense is drawn first, then variable expense is added to the fixed expense in order to draw the total expense line. Finally, the total revenue line is drawn. The total profit (or loss) is the vertical difference between the total revenue and total expense lines. www.notesolution.com total expenses total revenue D. Break-Even Analysis and Target Profit Analysis. Target profit analysis is concerned with estimating the level of sales required to attain a specified target profit. Break-even analysis is a special case of target profit analysis in which the target profit is zero. 1. Basic CVP equations. Both the equation and contribution (formula) methods of break- even and target profit analysis are based on the contribution approach to the income statement. The format of this statement can be expressed in equation form as: Profits = Sales − Variable expenses −Fixed expenses In CVP analysis this equation is commonly rearranged and expressed as: Sales = Variable expenses + Fixed expenses + Profits a. The above equation can be expressed in terms of unit sales: Price × Unit sales = Unit variable cost × Unit sales + Fixed expenses + Profits ⇓ Unit contribution margin × Unit sales = Fixed expenses + Profits ⇓ Fixed expenses + Profits Unit sales = Unit contributi on margin b. The basic equation can also be expressed in terms of sales dollars using the variable expense ratio: Sales = Variable expense ratio × Sales + Fixed expenses + Profits ⇓ (1 −Variable expense ratio) × Sales = Fixed expenses + Profits ⇓ Contribution margin ratio* × Sales = Fixed expenses + Profits ⇓ Fixed expenses + Profits Sales = Contributi on margin ratio Variable expenses * 1 −Variable expense ratio = 1− Sales Sales - Variable expenses = Sales www.notesolution.com = Contributi on margin Sales = Contribution margin ratio 2. Break-even point using the equation method. The break-even point is the level of sales at which profit is zero. It can also be defined as the point where total sales revenue equals total expenses or as the point where total contribution margin equals total fixed expenses. Break-even analysis can be approached either by the equation method or by the contribution margin method. The two methods are logically equivalent.
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