BUS105 Study Guide

Unit 5: Cost-Volume-Profit Analysis

5a. Perform cost-volume-profit analysis for single-product and multiple-product companies

  • What is the profit equation?
  • How is the profit equation used in conjunction with the contribution margin?
  • Why is it important to separate fixed costs from variable costs in the profit equation?
  • What is the break-even point, and why is it important?

Cost-volume-profit analysis identifies how changes in key assumptions such as costs, volume, or profit may impact financial projections. This analysis begins with the profit equation, which states that profit equals total revenues minus total variable costs and total fixed costs. This is sometimes known as the cost-volume-profit equation. This equation is useful to companies to help determine the break-even point in units, the break-even point in sales dollars, as well as the number of units needed to sell to reach a target profit.

For a company with multiple products, the equation must be expanded to include multiple products. This can be accomplished with the use of the contribution margin for each individual product. This equation states that profit is equal to the sum of the contribution margin for each product multiplied by the quantity sold for that product, minus fixed costs. So for a company with two products, called River and Sea, and fixed costs notated as F, the equation would be: 

Profit = (Unit CM for River × Quantity of River) + (Unit CM for Sea × Quantity of Sea) − F

Review Cost-Volume-Profit Analysis for Single-Product Companies and Cost-Volume-Profit Analysis for Multiple-Product and Service Companies.

5b. Perform sensitivity analysis using the cost-volume-profit model

  • How can the cost-volume-profit equation be used to determine the effects of changes to one or more of its variables?
  • How will changes to one or more variables of the CVP model affect the break-even point or target profit?

The cost-volume-profit model (CVP) can be used to analyze how changes to any of its variables will affect profitability. This is known as sensitivity analysis. This analysis can also be used to determine how changes to one or more of the variables can affect the break-even point and target profit. Managers can use sensitivity analysis to determine changes to things like production or sales prices or to analyze costs. 

For example, managers can use the CVP model to see what would happen if prices were increased by a few dollars. The contribution margin per unit would increase but would sales decrease? How would the break-even point change? What would happen if variable costs per unit would be decreased? The contribution margin would obviously increase. How would that affect the break-even point or target profit?

Review Using Cost-Volume-Profit Models for Sensitivity Analysis.

5c. Use an alternative form of contribution margins, such as contribution margin per unit of constraint, when faced with resource constraints

  • When faced with a constraint, why is it important to calculate an alternative form of the contribution margin?
  • What are three examples of production constraints?
  • How is the contribution margin per unit of constraint helpful to managers in decision-making?

Some companies may have limited resources in areas such as labor hours, machine hours, or materials. In that case, the normal contribution may not be very informative on its own. This is because although a company would like to produce more products with a higher contribution margin, if the constraint does not allow them to produce that many units, they will be unable to meet those production goals. Thus, an alternative measure called the contribution margin per unit of constraint is usually used in addition to the regular contribution margin per unit. This is the contribution margin per unit divided by the units of constrained resources required to produce one unit of product.

The contribution margin per unit of constraint allows management to see, within the framework of the constraints, which product has the highest contribution margin. Thus, the company can set its goals to produce more of these products. This will increase profits while working with the limited resources that are available. 

Review Using a Contribution Margin When Faced with Resource Constraints.

5d. Demonstrate the effect of income taxes on the cost-volume-profit model

  • Why is it important to account for income taxes when performing cost-volume-profit analysis?
  • What are the three steps needed for a company that incurs income taxes to find a break-even point or target profit?
  • What is the equation to convert target profit after taxes to target profit before taxes?

Since most companies pay income taxes on their profit, when using the cost-volume-profit equation, tax expense must be accounted for. This is done by determining the desired target profit after taxes, converting this amount to target profit before taxes and then using that new amount in the target profit formula. The formula to convert target profit to target profit after taxes is:

Target profit before taxes = Target profit after taxes + (1 − tax rate)

By making use of the target profit before taxes, firms can ensure that the desired profit will be met subsequent to paying taxes.

Review Income Taxes and Cost-Volume-Profit Analysis.

5e. Discuss the effects of absorption and variable costing on profits

  • What is the difference between absorption costing and variable costing?
  • Which method is required by Generally Accepted Accounting Principles (GAAP) and why?
  • Which method will lead to higher Gross Profit?
  • Which method will lead to higher net income?

Absorption costing is the costing method required by US GAAP. It requires that all costs associated with manufacturing costs, including fixed manufacturing costs, are included (or absorbed) into the cost of the product. Only non-manufacturing costs are treated as period costs. In managerial accounting, managers sometimes prefer the use of variable costing. This method only includes variable costs as part of the cost of goods sold while all fixed costs are treated as period costs. Thus, the use of absorption costing, with its higher cost of goods sold, will lead to a lower gross profit than the use of variable costing. 

Review Using Variable Costing to Make Decisions.

Unit 5 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • absorption costing
  • break-even point in sales 
  • break-even point in units
  • constraint
  • contribution margin per unit of constraint
  • cost-volume-profit analysis
  • cost-volume-profit equation
  • profit equation
  • sensitivity analysis
  • target profit
  • variable costing