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CVP analysis helps management understand the interrelationship between cost, volume and profit in an organization.It focuses on interactions between the following five elements:Prices of productsVolume or level of activityPer unit variable costsTotal fixed costsMix of products
Chapter 7Cost-Volume-Profit (CVP) Relationships CVP analysis helps management understand the interrelationship between cost, volume and profit THE BASICS OF COST-VOLUME-PROFIT ANALYSISThis is with what we start CVP analysis Contribution Margin?What does it mean?CM is the amount available to cover fixed For each additional speaker that the company is able to sell during If enough speakers can be sold to generate$35’000 in CM, then all Once the break-even point has been reached, net income will increase by The CM concepts helps us know what the profits will be at The CM concepts helps us know what the profits will be at Summary for CM:If there were no sales, the company loss would be Contribution Margin Ratio (CM Ratio)In addition to being expressed on a per 1. Calculate CM Ratio for Acoustic ConceptsComputation:2. What kind of information can 1. Calculate CM Ratio for Acoustic Concepts2. What kind of information can 5. Verify your statements about the changes in NI and CM by constructing income statements 5. Verify your statements about the changes in NI and CM by constructing income statements Some applications of CVP conceptsWe will use the following and other data:Recall Some applications of CVP conceptsWe will use the following and other data:Recall Some applications of CVP conceptsWe will use the following and other data:Recall Change in Variable Costs and Sales VolumeManagement has received an advice Change in Variable Costs and Sales VolumeManagement has received an advice Change in Fixed Costs, Sales Price, and Sales VolumeThe sales manager Change in Fixed Costs, Sales Price, and Sales VolumeThe sales manager Change in Variable Cost, Fixed Cost, and Sales VolumeThe sales manager Change in Variable Cost, Fixed Cost, and Sales VolumeThe sales manager Change in Regular Sales PriceThe company has an opportunity to make Change in Regular Sales PriceThe company has an opportunity to make Change in Regular Sales PriceThe company has an opportunity to make Importance of CM CVP analysis seeks the most profitable combination of variable BREAK-EVEN ANALYSISAnswers a question: How far sales could drop before the company Margin of Safety Margin of safety is the excess of budgeted CVP CONSIDERATIONS IN CHOOSING A COST STRUTURECost Structure is the relative proportion assume that each farm experiences a 10% increase in sales. Which What if sales can be expected to drop below $100’000 from Summary for Cost Structure and Profitability:Without knowing the future, it is not Operating LeverageOperating leverage is a measure of the extent to which Behavior:The degree of operating leverage is greatest at sales levels near the Summary for Operating leverage (don’t write this):A manager can use the degree If the next year’s revenues are expected be 115% of this year’s If the next year’s revenues are expected be 115% of this year’s Structuring sales commissionsPipeline Unlimited produces surfing equipment. Data for the company’s two products appears below:
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Слайд 2 CVP analysis helps management understand the interrelationship between

CVP analysis helps management understand the interrelationship between cost, volume and

cost, volume and profit in an organization.




It focuses on

interactions between the following five elements:
Prices of products
Volume or level of activity
Per unit variable costs
Total fixed costs
Mix of products sold

Слайд 3 THE BASICS OF COST-VOLUME-PROFIT ANALYSIS
This is with what

THE BASICS OF COST-VOLUME-PROFIT ANALYSISThis is with what we start CVP analysis

we start CVP analysis


Слайд 4 Contribution Margin?
What does it mean?
CM is the amount

Contribution Margin?What does it mean?CM is the amount available to cover

available to cover fixed expenses and then to provide

profits for the period.

Have you noted the sequence?

1

2

If a contribution margin is not sufficient to cover fixed expenses, then a loss occurs for the period.

Ex: Assume that Acoustic Concepts has been able to sell only one speaker, at that point, the company’s contribution income statement would appear as follows:


Слайд 5 For each additional speaker that the company is

For each additional speaker that the company is able to sell

able to sell during the month, $100 more in

CM will become available to help cover the fixed expenses.

If a second speaker is sold, for example, what will be the total CM to cover fixed expenses?


Слайд 6 If enough speakers can be sold to generate$35’000

If enough speakers can be sold to generate$35’000 in CM, then

in CM, then all of the fixed costs will

be covered and the company will have managed to at least break even for the month – that is, to show neither profit nor loss, but just cover fixed costs for the month.

So, how many speakers should we sell in order to reach the Break Even Point?

Break Even Point – the point where total sales revenue equals total expenses, or – the point where total CM equals total fixed expenses.


Слайд 7 Once the break-even point has been reached, net

Once the break-even point has been reached, net income will increase

income will increase by the unit CM for each

additional unit sold.

If 351 speakers are sold in a month, on how much will our income increase compared to break-even sales?

If 352 speakers are sold?

So WHAT?


Слайд 8 The CM concepts helps us know what the

The CM concepts helps us know what the profits will be

profits will be at various levels of activity without

the need to prepare a whole series of income statements.

We just:

Take the number of units to be sold over a break-even point


Unit CM

×

Ex: Assume that Acoustic Concepts is selling 400 speakers per month and plans to increase the sales to 425 speakers per month. What impact will be on profits of the company?

=


Expected Profit


Слайд 9 The CM concepts helps us know what the

The CM concepts helps us know what the profits will be

profits will be at various levels of activity without

the need to prepare a whole series of income statements.

We just:

Take the number of units to be sold over a break-even point


Unit CM

×

Ex: Assume that Acoustic Concepts is selling 400 speakers per month and plans to increase the sales to 425 speakers per month. What impact will be on profits of the company?

=


Expected Profit

These calculations can be verified as follows:


Слайд 10 Summary for CM:
If there were no sales, the

Summary for CM:If there were no sales, the company loss would

company loss would be equal its fixed expenses.
Each unit

that is sold, reduces the loss by the amount of the unit CM
Once the break-even point has been reached, each additional unit sold increases the company’s profit by the amount of the unit CM.

Слайд 11 Contribution Margin Ratio (CM Ratio)
In addition to being

Contribution Margin Ratio (CM Ratio)In addition to being expressed on a

expressed on a per unit basis, revenues, variable expenses,

and CM for Acoustics Concepts can be expressed on a percentage basis:

Using the CM RATIO, the impact on Net Income of any given dollar change in total sales can be computed in seconds by simply applying the CM ratio to the dollar change.


Слайд 12 1. Calculate CM Ratio for Acoustic Concepts
Computation:


2. What

1. Calculate CM Ratio for Acoustic ConceptsComputation:2. What kind of information

kind of information can you reveal from your computations?
3.

What will be the increase in CM if Acoustic Concepts plans to increase sales in the next month by $30’000?

4. If fixed costs don’t change during the coming months, what will be the change in NI?


Слайд 13 1. Calculate CM Ratio for Acoustic Concepts
2. What

1. Calculate CM Ratio for Acoustic Concepts2. What kind of information

kind of information can you reveal from your computations?

For each dollar increase in sales, total CM will increase by 40 cents.
If there is no change in fixed costs, then NI will also increase by 40 cents.

3. What will be the increase in CM if Acoustic Concepts plans to increase sales in the next month by $30’000?

$30’000 increased sales × CM Ratio of 40% = $12’000 increase in sales

4. If fixed costs don’t change during the coming months, what will be the change in NI?

Net Income will also increase by $12’000


Слайд 14 5. Verify your statements about the changes in

5. Verify your statements about the changes in NI and CM by constructing income statements

NI and CM by constructing income statements


Слайд 15 5. Verify your statements about the changes in

5. Verify your statements about the changes in NI and CM by constructing income statements

NI and CM by constructing income statements


Слайд 16 Some applications of CVP concepts
We will use the

Some applications of CVP conceptsWe will use the following and other

following and other data:
Recall that F. exp. equal $35’000

Change in Fixed Costs and Sales Volume

Acoustic Concepts is currently selling 400 speakers per month (monthly sales of $100’000). The sales manager feels that a $10’000 increase in monthly advertising budget would increase monthly sales by $30’000. Should the advertising budget be increased?


Слайд 17 Some applications of CVP concepts
We will use the

Some applications of CVP conceptsWe will use the following and other

following and other data:
Recall that F. exp. equal $35’000

Change in Fixed Costs and Sales Volume

Acoustic Concepts is currently selling 400 speakers per month (monthly sales of $100’000). The sales manager feels that a $10’000 increase in monthly advertising budget would increase monthly sales by $30’000. Should the advertising budget be increased?

If we don’t know the previous sales, we could come to this solution like this:


Слайд 18 Some applications of CVP concepts
We will use the

Some applications of CVP conceptsWe will use the following and other

following and other data:
Recall that F. exp. equal $35’000

Change in Fixed Costs and Sales Volume

Acoustic Concepts is currently selling 400 speakers per month (monthly sales of $100’000). The sales manager feels that a $10’000 increase in monthly advertising budget would increase monthly sales by $30’000. Should the advertising budget be increased?

If we don’t know the previous sales, we could come to this solution like this:

Here, we used an incremental analysis.
Incremental analysis considers only those items of revenue, cost, and volume that will change if the new program or project is implemented.

Yes, based on the information presented, and assuming that other factors in the company don’t change, the advertising budget should be increased.


Слайд 19 Change in Variable Costs and Sales Volume
Management

Change in Variable Costs and Sales VolumeManagement has received an

has received an advice about higher-quality components, which, as

the sales manager predicts, would increase sales to 480 speakers per month, however the use of these higher-quality components will increase variable costs (and thereby reduce CM) by $10 per speaker. Should the higher-quality components be used?

Слайд 20 Change in Variable Costs and Sales Volume
Management

Change in Variable Costs and Sales VolumeManagement has received an

has received an advice about higher-quality components, which, as

the sales manager predicts, would increase sales to 480 speakers per month, however the use of these higher-quality components will increase variable costs (and thereby reduce CM) by $10 per speaker. Should the higher-quality components be used?

Yes, based on the information above, the higher-quality components should be used.


Слайд 21 Change in Fixed Costs, Sales Price, and

Change in Fixed Costs, Sales Price, and Sales VolumeThe sales

Sales Volume
The sales manager would like to cut the

selling price by $20 per speaker and increase the advertising budget by $15’000 per month. He argues that if these two steps are taken, unit sales will increase by 50%. Should the changes be made?

Слайд 22 Change in Fixed Costs, Sales Price, and

Change in Fixed Costs, Sales Price, and Sales VolumeThe sales

Sales Volume
The sales manager would like to cut the

selling price by $20 per speaker and increase the advertising budget by $15’000 per month. He argues that if these two steps are taken, unit sales will increase by 50%. Should the changes be made?

We would obtain the same conclusion if we have constructed income statements using contribution format.


Слайд 23 Change in Variable Cost, Fixed Cost, and

Change in Variable Cost, Fixed Cost, and Sales VolumeThe sales

Sales Volume
The sales manager would like to place the

sales staff on a commission basis of $15 per speaker sold, rather than on flat salaries that now total $6’000 per month. He is confident, that the change will increase monthly sales by 15%. Should the change be made?

Слайд 24 Change in Variable Cost, Fixed Cost, and

Change in Variable Cost, Fixed Cost, and Sales VolumeThe sales

Sales Volume
The sales manager would like to place the

sales staff on a commission basis of $15 per speaker sold, rather than on flat salaries that now total $6’000 per month. He is confident, that the change will increase monthly sales by 15%. Should the change be made?

Yes, the changes should be made

We would obtain the same conclusion if we have constructed income statements using contribution format.


Слайд 25 Change in Regular Sales Price
The company has

Change in Regular Sales PriceThe company has an opportunity to

an opportunity to make a bulk sale of 150

speakers to a wholesaler if an acceptable price can be worked out. This sale would not disturb the company’s regular sales. What price per speaker should be quoted to the wholesaler if Acoustic Concepts wants to increase its monthly profits by $3’000?

Слайд 26 Change in Regular Sales Price
The company has

Change in Regular Sales PriceThe company has an opportunity to

an opportunity to make a bulk sale of 150

speakers to a wholesaler if an acceptable price can be worked out. This sale would not disturb the company’s regular sales. What price per speaker should be quoted to the wholesaler if Acoustic Concepts wants to increase its monthly profits by $3’000?

Слайд 27 Change in Regular Sales Price
The company has

Change in Regular Sales PriceThe company has an opportunity to

an opportunity to make a bulk sale of 150

speakers to a wholesaler if an acceptable price can be worked out. This sale would not disturb the company’s regular sales. What price per speaker should be quoted to the wholesaler if Acoustic Concepts wants to increase its monthly profits by $3’000?

Слайд 28 Importance of CM
CVP analysis seeks the most

Importance of CM CVP analysis seeks the most profitable combination of

profitable combination of variable costs, fixed costs, selling price,

and sales volume.

In applying CVP analysis very often we see that the effect on the CM is a major consideration in deciding on the most profitable combination of these factors.

The size of the unit CM figure (and the size of the CM ratio) will have a heavy influence on what steps a company is willing to take to improve profits.

Ex: The greater the unit CM for a product, the greater is the amount that a company will be willing to spend in order to increase unit sales of the product by a given percentage.

Слайд 29 BREAK-EVEN ANALYSIS
Answers a question: How far sales could

BREAK-EVEN ANALYSISAnswers a question: How far sales could drop before the

drop before the company begins to lose money?
Two approaches

to Break-Even analysis:
Equation Method
Contribution Margin Method

Change in Regular Sales Price


Слайд 30 Margin of Safety
Margin of safety is

Margin of Safety Margin of safety is the excess of

the excess of budgeted (or actual) sales over the

break-even volume of sales. The amount by which sales can drop before losses begin to be incurred.

Formula for margin of safety:

Total Sales – Break-even Sales = Margin of Safety

Margin of safety can also be obtained in a percentage form:

Ex: For Acoustic Concepts, whose sales in units are 400, BE sales are 350 speakers and per unit sales price is $250. Calculate the margin of safety in dollars and as a percentage of sales.

This margin of safety means that at the current level of sales and with the company’s current prices and cost structure, a reduction in sales of $12’500 or 12.5%, would result in just break even.


Слайд 31 CVP CONSIDERATIONS IN CHOOSING A COST STRUTURE
Cost Structure

CVP CONSIDERATIONS IN CHOOSING A COST STRUTURECost Structure is the relative

is the relative proportion of fixed and variable costs

in an organization.

Cost Structure and Profit Stability

Which cost structure is better – high variable costs and low fixed costs, or the opposite?

Ex: Let’s look at two blueberry farms:

Bogside Farm
depends on migrant workers to pick its berries by hand
has higher variable costs

Sterling Farm
has invested in expensive berry-picking machines
has higher fixed costs


Слайд 32 assume that each farm experiences a 10%

assume that each farm experiences a 10% increase in sales.

increase in sales. Which farm would earn more?
We could

have come to the same result by multiplying the increase in sales by the CM ratio for the companies:

As we would expect, for the same dollar increase in sales, Sterling Farm has experienced a greater increase in NI due to its higher CM ratio.


Слайд 33 What if sales can be expected to

What if sales can be expected to drop below $100’000

drop below $100’000 from time to time?
What are

the BEPs of the two farms?
What are their margins of safety?

This analysis makes it clear that Bogside Farm is less vulnerable to downturns than Sterling Farm, for two reasons:
Lower fixed expenses → lower BEP → higher margin of safety. It’s sales may drop more than for Sterling before this farm begins to lose money.
Lower CM ratio. When sales fall off, the Bogside will not lose CM as rapidly as Sterling.

Thus, Bogside’s NI will be less volatile, although this is a drawback when sales increase, it provides more protection when sales drop.


Слайд 34 Summary for Cost Structure and Profitability:

Without knowing the

Summary for Cost Structure and Profitability:Without knowing the future, it is

future, it is not obvious which cost structure is

better.

Both have advantages and disadvantages

A company with higher F.C. and lower V.C. will experience wider swings in NI due to changes in sales volume.

A company with lower F.C. and higher V.C. will enjoy greater stability in NI and will be more protected during bad years, but at the cost of lower NI in good years.

Слайд 35 Operating Leverage
Operating leverage is a measure of

Operating LeverageOperating leverage is a measure of the extent to

the extent to which fixed costs are being used

in an organization.
If a company has high operating leverage, then profits will be very sensitive to changes in sales.
Just as in our example with blueberry farms, where the Sterling farm had a greater operating leverage as a result of the greater amount of F.C. in its structure.

Formula for the Degree of Operating Leverage:

Calculate the Degree of Operating Leverage for our farms:

Degree of operating leverage is a measure, at a given level of sales, of how a percentage change in in sales volume will affect profits.

These figures tell us that for a given percentage change in sales we can expect a change four times as great in the NI for Bogside Farm and a change seven times as great in the NI of Sterling Farm.


Слайд 36 Behavior:
The degree of operating leverage is greatest at

Behavior:The degree of operating leverage is greatest at sales levels near

sales levels near the BEP and decreases as sales

and profits rise.

Ex: Degree of operating leverage for a Bogside Farm at various sales levels.

Thus, a 10% increase in sales would increase profits by only 15% (10% × 1.5X) if the company were operating at a $225’000 sales level, as compared to the 40% increase we computed earlier at the $100’000 sales level.

The degree of operating leverage will continue to decrease the farther the company moves from its BEP.


Слайд 37 Summary for Operating leverage (don’t write this):

A manager

Summary for Operating leverage (don’t write this):A manager can use the

can use the degree of operating leverage to quickly

estimate what impact various percentage changes in sales will have on profits, without the necessity of preparing income statements.

If a company is fairly near its BEP, then even small increases in sales can yield large increases in profits.

This explains why management sometimes work very hard for only a small increase in sales volume.

If the DOL is 5X, then a 6% increase in sales would translate into a 30% increase in profits.

Слайд 39 If the next year’s revenues are expected be

If the next year’s revenues are expected be 115% of this

115% of this year’s sales, what percentage increase in

NI we would expect for the company?

Слайд 40 If the next year’s revenues are expected be

If the next year’s revenues are expected be 115% of this

115% of this year’s sales, what percentage increase in

NI we would expect for the company?

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