978-1111971724 Kinney 9e IM Ch 09 Lecture Note Part 1

Learning Objectives

1. What is the break-even point (BEP) and why is it important?

2. How is the BEP determined and what methods are used to identify BEP?

decision making?

4. How do break-even and CVP analysis differ for single-product and multiproduct firms?

BREAK-EVEN POINT AND COST-VOLUME-

PROFIT ANALYSIS

CHAPTER

9

Chapter 09: Break-Even Point and Cost-Volume-Profit Analysis IM 2

Terminology

Break-even chart: a graph that depicts the relationships among revenue, volume, variable costs, fixed

Break-even point (BEP): the level of activity, in units or dollars, at which total revenues equal total costs

Contribution margin ratio (CM%): the proportion of each revenue dollar remaining after variable costs

Degree of operating leverage (DOL): a factor that indicates how a percentage change in sales from the

Incremental analysis: a process of evaluating alternatives that focuses only on the factors that change

Margin of safety (MS): the excess of the budgeted or actual sales of a company over break-even sales;

Operating leverage: the proportionate relationship between a company’s variable and fixed costs

Variable cost ratio (VC%): the proportion of each revenue dollar needed to cover variable costs;

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Lecture Outline

LO.1: What is the break-even point (BEP) and why is it important?

A. Introduction

1. Much of the information managers use to plan and control reflects relationships among product

components.

2. This chapter focuses on understanding how costs, volumes, and profits interact.

B. Break-even Point

1. Variable costing is commonly used for internal purposes because it makes cost behavior more

transparent.

models.

b. A variable costing income statement for Calispell Company is presented in text Exhibit 9.1

2. The break-even point (BEP) is the level of activity, in units or dollars, at which total revenues

equal total costs.

from operations rather than losses.

3. Several simplifying assumptions must be made concerning revenue and cost functions (These

are discussed in more detail at the end of the chapter):

factors such as quantity discounts are ignored;

c. Variable costs: Total variable costs fluctuate in direct proportion to the level of activity or

costs are assumed to be fixed;

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d. Fixed costs: Total fixed costs are assumed to remain constant within the relevant range.

Fixed cost per unit decreases as volume increases, and increases as volume decreases.

Fixed costs include both fixed manufacturing overhead and fixed selling and administrative

expenses; and

4. Contribution margin (CM) is the difference between revenue and variable cost. CM may be

b. CM fluctuates in direct proportion to sales volume. Since unit revenue and unit variable cost

LO.2: How is the BEP determined and what methods are used to identify BEP?

C. Identifying the Break-even Point

1. Formula Approach to Breakeven

a. The formula approach uses an algebraic equation to calculate the exact break-even point.

c. Algebraic break-even computations use an equation that represents the variable costing

volume, and profit as follows:

R(X) – VC(X) – FC = P

where R = revenue (selling price) per unit

X = number of units sold or to be sold

formula to indicate a break–even situation.

ii. The break-even point in units can be found by solving the equation for X:

X = FC ÷ (R – VC)

iii. Break-even point volume is equal to total fixed cost divided by the unit contribution

contribution margin per unit

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on a total or per unit basis.

ii. The variable cost (VC) ratio represents the variable cost proportion of each revenue

Sales = FC ÷ (1 – VC%)

or

Sales = FC ÷ CM%

2. Graphing Approach to Breakeven

a. Sometimes BEP information may be more effectively conveyed to managers in a visual

format.

i. Text Exhibit 9.2 (p. 357) provides a visual representation of Calispell Company’s

revenue, cost and contribution margin behaviors.

b. Traditional Approach

and fixed cost lines.

 The fixed cost line is drawn parallel to the x-axis.

 The variable cost line begins where the fixed cost line intersects the y-axis. The slope

ii. Step 2: Graph the total revenue line.

price.

iii. The BEP is located at the intersection of the total revenue line and the total cost line.

 The vertical distance to the right of the BEP and between the revenue and total cost

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iv. Text Exhibit 9.4 (p. 358) presents a traditional CVP graph for Calispell Company.

c. Profit-Volume Graph

i. The profit-volume graph is a visual representation of the amount of profit or loss

d. Income Statement Approach

i. The income statement approach to CVP analysis allows the preparation of pro forma

ii. Income statements can be used to prove the accuracy of computations made with the

3. The break-even point provides a starting point for planning future operations.

a. Managers want to earn profits, not just cover costs, so the break-even point formula can be

used by substituting an amount other than zero for the profit (P) term.

b. This substitution converts break–even analysis to cost-volume-profit analysis.

LO.3: What is cost-volume-profit (CVP) analysis and how do companies use CVP information in

decision making?

D. CVP Analysis

1. General

a. Cost-volume-profit analysis is a procedure that examines changes in costs and volume

levels and the resulting effects on profits.

i. CVP analysis can be used to calculate the sales volume necessary to achieve a desired

b. Managers use CVP to plan and control more effectively since the technique allows them to

i. The CVP model can be expressed through a formula or as a graph.

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c. CVP analysis requires the substitution of known amounts in the formula to determine an

d. A significant application of CVP analysis is the setting of a desired target profit and focusing

accomplish this objective.

ii. Selling price is not as common an unknown as volume since the selling price is usually

e. Profits may be stated as either a fixed or variable amount and on either a before-tax or after-

tax basis.

2. Fixed Amount of Profit

i. Before Tax

 The formula to compute target profit before tax is as follows:

ii. After Tax

PBT – [(TR) (PBT)] = PAT

and

 PBT is further defined as:

PBT – (1 – TR) = PAT or

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(R – VC)(X) = FC + [PAT ÷ (1 – TR)] or

CM(X) = FC + [PAT ÷ (1 – TR)]

3. Specific Amount of Profit Per Unit

a. Managers may desire a specific amount of profit per unit, in which case, profit must be

i. A set amount of profit can be stated on either a before tax or after tax basis or as either a

b. Before Tax

i. Text Exhibit 9.8 (p. 363) provides an analysis of a set amount of profit per unit before

tax.

ii. The adjusted CVP formula for computing the necessary unit sales volume to earn a

specified amount of profit before tax per unit is as follows:

X = FC ÷ (CM – PuBT)

c. After Tax

i. Text Exhibit 9.9 (p. 364) provides an analysis of a set amount of profit per unit after tax

ii. The adjusted CVP formula for computing the necessary unit sales volume to earn a

specified amount of profit after tax per unit is as follows:

4. Incremental Analysis for Short-Run Changes

a. Incremental analysis is a process of evaluating changes that focuses only on the factors

b. The break-even point may increase or decrease, depending on the particular changes that

occur in the revenue and cost factors.

ii. A decrease in contribution margin could arise due to a reduction in selling price, an

iii. The break-even point will decrease if there is a decrease in total fixed cost or an increase

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c. Any factor that causes a change in the break-even point will also cause a shift in total profits

d. The text presents four examples (cases) of changes in the CVP variables that could occur

LO.4: How do break-even and CVP analysis differ for single-product and multiproduct firms?

E. CVP Analysis in a Multiproduct Environment

1. A constant product sales mix or, alternatively, an average contribution margin ratio must be

assumed in order to perform CVP analysis in a multiproduct company.

margin.

i. Note that it is the sum of all of the products’ individual product CM multiplied by its weight

or mix proportion.

4. Any shift in the sales mix proportion of products will change the weighted average contribution

margin and the break-even point.

LO.5: How are margin of safety and operating leverage concepts used in business?

F. Managing Risk of CVP Relationships

1. Margin of Safety

a. The margin of safety is the excess of the budgeted or actual sales of a company over its

degree of operating leverage).