2) What is the company’s break-even sales? 3) Should the selling price be changed? 4) Should the company spend more on advertising? 5) What profit contribution can be realized if the organization performs as expected for the period? 6) Should the product be sold as is or should it be processed further? 7) What would be the effects of the changes in the cost of materials and in the efficiency of production? Long-run decisions : such as buying a new plant and equipment also need predictions of the resulting cost-volume-profit relationship Significance of CVP Analysis Helps managers understand the interrelationship between cost, volume and profit in an organization by focusing on interactions between the following five elements : 1. Prices of products 2. Volume or level of activity within relevant range 3. Variable cost per unit 4. Total fixed costs 5. Mix of products sold
COLLEGE OF ACCOUNTING EDUCATION 3F Facundo Hall, Business and Engineering Building Matina Campus, Davao City Telefax: (082)305-5456 Phone No.: (082)300-5456 Local 137 39 Assumptions and Limitations To give you a heads-up, below are some underlying assumptions upon which the CVP analysis rests which place definite limitations on the conclusions which can be drawn from its results. Whenever these underlying assumptions do not correspond to a given situation, the limitations of the analysis must be clearly recognized if the break-even tool is to be useful. 1. The analysis is valid only within the relevant range in a limited period of time. 2. All costs can be categorized as fixed or variable. 3. Variable costs change proportionately with volume (linear rate). 4. Fixed costs are constant within the relevant volume range. 5. Selling prices do not change as sales volume changes. 6. For multi-products, the sales mix remains constant. 7. Productive efficiency does not change. 8. Inventory levels remain constant (i.e. in physical units, sales equals production). 9. Volume is the only relevant factor affecting costs and revenues. CVP ANALYSIS: BREAK-EVEN PLANNING The starting point in many business plans is determining the break-even point. Break-even point (BEP) is the level of sales volume where: Total Revenues = Total Expenses, thus, operation results to: NO PROFIT / NO LOSS BEP Planning Methods: 1. Operating Income approach; 2. Contribution Margin approach; and, 3. Graphical approach Operating Income Approach (Equation Method) This approach focuses on the income statement as a useful tool in organizing the firm’s costs into fixed and variable categories. The income statement can be expressed as an: Equation Sales xxx Variable Costs (xxx) Contribution Margin xxx Fixed Costs (xxx) Operating Income xxx At Break-even Point: Break-even Sales = Variable Costs + Fixed Costs Break-even Sales = Total Costs
COLLEGE OF ACCOUNTING EDUCATION 3F Facundo Hall, Business and Engineering Building Matina Campus, Davao City Telefax: (082)305-5456 Phone No.: (082)300-5456 Local 137 40 Contribution Margin Approach (Formula Method) This approach is a refinement of the operating income approach. In effect, we are simply recognizing that:
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