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Finance Aspect-cost of capital

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4.
Cost-volume-profit (CVP) analysis expands the use of information provided by
breakeven analysis. A critical part of CVP analysis is the point where total revenues
equal total costs (both fixed and variable costs). At this breakeven point (BEP), a
company will experience no income or loss. This BEP can be an initial examination that
precedes more detailed CVP analyses.
Cost-volume-profit analysis employs the same basic assumptions as in breakeven
analysis. The assumptions underlying CVP analysis are:
1. The behavior of both costs and revenues in linear throughout the relevant range of
activity. (This assumption precludes the concept of volume discounts on either
purchased materials or sales.)
2. Costs can be classified accurately as either fixed or variable.
3. Changes in activity are the only factors that affect costs.
4. All units produced are sold (there is no ending finished goods inventory).
5. When a company sells more than one type of product, the sales mix (the ratio of
each product to total sales) will remain constant.
In the following discussion, only one product will be assumed. Finding the breakeven
point is the initial step in CVP, since it is critical to know whether sales at a given level
will at least cover the relevant costs. The breakeven point can be determined with a
mathematical equation, using contribution margin, or from a CVP graph. Begin by
observing the CVP graph in Figure 1, where the number of units produced equals the
number of units sold. This figure illustrates the basic CVP case. Total revenues are zero
when output is zero, but grow linearly with each unit sold. However, total costs have a
positive base even at zero output, because fixed costs will be incurred even if no units are
produced. Such costs may include dedicated equipment or other components of fixed
costs. It is important to remember that fixed costs include costs of every kind, including
fixed sales salaries, fixed office rent, and fixed equipment depreciation of all types.
Variable costs also include all types of variable costs: selling, administrative, and
production. Sometimes, the focus is on production to the point where it is easy to
overlook that all costs must be classified as either fixed or variable, not merely product
costs.
Where the total revenue line intersects the total costs line, breakeven occurs. By drawing
a vertical line from this point to the units of output (X) axis, one can determine the
number of units to break even. A horizontal line drawn from the intersection to the
dollars (Y) axis would reveal the total revenues and total costs at the breakeven point. For
units sold above the breakeven point, the total revenue line continues to climb above the
total cost line and the company enjoys a profit. For units sold below the breakeven point,
the company suffers a loss.
Illustrating the use of a mathematical equation to calculate the BEP requires the
assumption of representative numbers. Assume that a company has total annual fixed cost

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of $480,000 and that variable costs of all kinds are found to be $6 per unit. If each unit
sells for $10, then each unit exceeds the specific variable costs that it causes by $4. This
$4 amount is known as the unit contribution margin. This means that each unit sold
contributes $4 to cover the fixed costs. In this intuitive example, 120,000 units must be
produced and sold in order to break even. To express this in a mathematical equation,
consider the following abbreviated income statement:
Unit Sales = Total Variable Costs + Total Fixed Costs + Net Income
Inserting the assumed numbers and letting X equal the number of units to break even:
$10.00X = $6.00X + $480,000 + 0
Note that net income is set at zero, the breakeven point. Solving this algebraically
provides the same intuitive answer as above, and also the shortcut formula for the
contribution margin technique:
Fixed Costs ÷ Unit Contribution Margin = Breakeven Point in Units
$480,000 ÷ $4.00 = 120,000 units
If the breakeven point in sales dollars is desired, use of the contribution margin ratio is
helpful. The contribution margin ratio can be calculated as follows:
Unit Contribution Margin ÷ Unit Sales Price = Contribution Margin Ratio
$4.00 ÷ $10.00 = 40%
To determine the breakeven point in sales dollars, use the following mathematical
equation:
Total Fixed Costs ÷ Contribution Margin Ratio = Breakeven Point in Sales Dollars
$480,000 ÷ 40% = $1,200,000
The margin of safety is the amount by which the actual level of sales exceeds the
breakeven level of sales. This can be expressed in units of output or in dollars. For
example, if sales are expected to be 121,000 units, the margin of safety is 1,000 units
over breakeven, or $4,000 in profits before tax.
A useful extension of knowing breakeven data is the prediction of target income. If a
company with the cost structure described above wishes to earn a target income of
$100,000 before taxes, consider the condensed income statement below. Let X = the
number of units to be sold to produce the desired target income:
Target Net Income = Required Sales Dollars − Variable Costs − Fixed Costs
$100,000 = $10.00X − $6.00X − $480,000
Solving the above equation finds that 145,000 units must be produced and sold in order
for the company to earn a target net income of $100,000 before considering the effect of
income taxes.
A manager must ensure that profitability is within the realm of possibility for the
company, given its level of capacity. If the company has the ability to produce 100 units
in an 8-hour shift, but the breakeven point for the year occurs at 120,000 units, then it
appears impossible for the company to profit from this product. At best, they can produce

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4. Cost-volume-profit (CVP) analysis expands the use of information provided by breakeven analysis. A critical part of CVP analysis is the point where total revenues equal total costs (both fixed and variable costs). At this breakeven point (BEP), a company will experience no income or loss. This BEP can be an initial examination that precedes more detailed CVP analyses. Cost-volume-profit analysis employs the same basic assumptions as in breakeven analysis. The assumptions underlying CVP analysis are: 1. The behavior of both costs and revenues in linear throughout the relevant range of activity. (This assumption precludes the concept of volume discounts on either purchased materials or sales.) 2. Costs can be classified accurately as either fixed or variable. 3. Changes in activity are the only factors that affect costs. 4. All units produced are sold (there is no ending finished goods inventory). 5. When a company sells more than one type of product, the sales mix (the ratio of each product to total sales) will remain constant. In the following discussion, only one product will be assumed. Finding the breakeven point is the initial step in CVP, since it is critical to know whether sales at a given level will at least cover the relevant costs. The breakeven point can be determined with a mathematical equation, using contribution margin, or from a CVP graph. Begin by observing the CVP graph in Figure 1, where the number of units produced equals the number of units sold. T ...
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