false

Textbook Notes
(368,326)

Canada
(161,799)

University of Toronto St. George
(10,695)

Rotman Commerce
(999)

RSM222H1
(43)

Donna Losell
(5)

Chapter 7

Unlock Document

Rotman Commerce

RSM222H1

Donna Losell

Fall

Description

Chapter 7: Cost-Volume-Profit Relationships
Knowing what the break even level of activity is helps management and other stakeholders such
as investors and lenders to evaluate the cushion (if any) between a companys expected level of
sales and the level required to just earn a $0 profit
CVP analysis is a powerful tool that helps managers to understand the relationships among cost,
volume, and profit
It focuses on how profits are affected by the following 5 elements:
o Prices of products
o Volume or level of activity
o Per unit variable costs
o Total fixed costs
o Mix of products sold
This is vital for decision making because this analysis helps managers understand how profits are
affected by these factors ^
THE BASICS OF COST VOLUME PROFIT ANALYSIS
Contribution income statement emphasizes the behaviour of costs and therefore is extremely
helpful to a manager in judging the impact on profits of change in selling price, cost, or volume
o Sales – variables expenses = CM – fixed expenses = Operating income
Reports sales, var expenses, and CM on both a per unit basis and a total basis
Use operating income as a measure of profit
Contribution Margin
CM is the amount remaining from sales revenue after variable expenses have been deducted
o Therefore it is the amount available to cover fixed expenses and then to provide profits for
the period
o First used to cover fixed expenses and then whatever remains goes towards profit …first
comes the fixed tho!
If CM is not enough to cover the fixed exps, then a loss occurs for the period
For each additional X product that the company Is able to sell, $X more in CM will become
available to help cover the fixed exps
Break even point: the level of sales at which profit is zero; can also be defined as the point where
total sales = total expenses, or as the point where total CM = total fixed expenses; sales – variable exps
– fixed exps = $0
o Once this is reached, operating income will increase by the unit CM for each additional unit
sold
To estimate profit at any sales level above the break even point, multiple the # of units sold in
excess of the point by the unit CM
To estimate the effect of a planned increase in sales on profits, can multiply the increase in units
sold by the unit CM
o Result will be the expected increase in operating income
If sales are 0, the companys operating loss would equal its fixed exps
Assumptions: selling price per unit, variable exps per unit, and total fixed exps remain constant
even for large changes in sales volumes CVP RELATIONSHIPS IN GRAPHIC FORM
Preparing the CVP graph
Sometimes called a break even chart
Shows the relationships among revenues, costs, and level of activity presented in graphic form
Unit volume usually on x axis and dollars on y axis
Involves 3 steps
o Draw a line parallel to the volume axis to represent total fixed exps
o Choose some volume of sales ad plot the point representing total exps (fixed plus variable)
at the activity level selected
Then draw line through it back to the point where the fixed exps line intersects the
dollars axis
o Again choose some sales volume and plot the point representing total sales dollars at the
activity level selected
When sales are below the break even point then the company incurs a loss
o When above, earn profit
Another easier graph is the profit graph:
o Profit= unit CM * Q – fixed exps
Plots a straight line; break even point will be the volume of sales at which profit is zero
CONTRIBUTION MARGIN RATIO
Is expressed as a % of total sales;
o CM ratio= CM/Sales
Shows how the CM will be affected by a change in total sales
Eg. 40% which means that for each dollar increase in sales, total CM will increase by 40 cents
o Operating income will also increase by 40 cents, assuming that the fixed costs are not
affected by the increase in sales
The effect on operating income of any dollar change in total sales can be computed b simply
adding the CM ratio to the dollar change
When trying to increase sales, products that yield the greatest amount of CM per dollar of sales
should be emphasized
SOME APPLICATIONS OF CVP CONCEPTS
Change in Fixed Cost and Sales Volume
Alternative 1** (pg 277)
o Expected total CM (expected sales x CM ratio) –
present total CM margin (current sales x CM ratio) =
incremental CM (or decremental) –
incremental advertising expense (for example) =
operating income (increase or decrease)
This case can be presented in an even shorter format bc only the fixed costs and sale volume
change
o Alternative 2:
Incremental CM margin-
Incremental advertising exp Increased operating income
Incremental analysis: approach that focuses only on those items of revenue, cost, and volume that
will change as a result of a decision
o More direct and focuses attention on the specific items involved in the decision
Change in Variable Costs and Sales Volume
Pg 278
Change in Fixed Costs, Selling Price, and Sales Volume
Pg 278
Change in Variable Cost, Fixed Cost, and Sales Volume
Pg 279
Change in Regular Selling Price
No fixed exps are included in computation bc they are not affected by the bulk sale, so all
additional revenue that is in excess of variable costs goes to increasing the profits of the company
Managers should consider both the short term and long term strategic consequences of their
decision before accepting or rejecting such opportunities
Importance of the CM
CVP seeks the most profitable combination of variable costs, fixed costs, selling price and sales
volume
o Effect on the CM is a major consideration in deciding on the most profitable combination of
these factors
Profits can be improved by reducing the CM if fixed costs can be reduced by a greater amount
Way to improve profits is to increase the total CM
o Can be done by reducing the selling price and therefore increasing volume
o Increasing the fixed costs (like advertising) and therefore increasing volume
o Trading off variable and fixed costs w appropriate changes in volume
The amount of the unit CM (and size of ratio) will have a significant impact on the steps a company
will take to improve profit; the greater the unit CM, the greater the amount the company may be
willing to spend in order to increase sales
Decision Rule:
Make change if:
Increase in CM > increase in fixed costs;
Decrease in CM < decrease in fixed costs

More
Less
Related notes for RSM222H1

Join OneClass

Access over 10 million pages of study

documents for 1.3 million courses.

Sign up

Join to view

Continue

Continue
OR

By registering, I agree to the
Terms
and
Privacy Policies

Already have an account?
Log in

Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.