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RSM222H1 (43)
Chapter 7

Chapter 7- rsm222.docx

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Rotman Commerce
Donna Losell

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
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