 Hello and welcome to this session in which you would look at cost volume profit analysis for short known as CVP. What is cost volume profit analysis? Simply put it's a tool. It's a tool to do what? It's a tool to help managers make business decision. Now how do we use this tool? Well you have to understand what is cost volume profit analysis. The best way to understand it is to break down the components of this formula cost volume profit and see what each one means and see how it's all put together. Starting with the cost. What is cost? What do we know about cost? Well we have two type of cost. We need to understand that we have variable cost. Cost that varies with the production with the selling of each additional unit will incur this cost. So it varies with sales, it varies with production. An example of it if you're a manufacturer in a car every car need four tires. So every car you produce you need at least four tires at least four tires. So it varies. The tires are variable cost in terms of car production. Fixed cost is a cost that does not change with production. So if you again if we're discussing the car manufacturing Ford Motor Company. Well in one manufacturing plan they might produce 100 cars or 500 cars. It does not matter. The depreciation of the equipment does not really matter because it's a fixed cost. If they are renting a warehouse to produce those cars the rental cost does not change. It's a fixed cost so it doesn't vary with the production. And the assumption here is you know what variable cost and fixed cost. In this session sometime I would refer to them as variable expenses and fixed expenses. It doesn't matter whether I used cost or expense. It's the same thing. So this is what cost is. Volume. What is a volume? Volume deals with quantity. Quantity of units sold or produce. Okay. So we need to understand what is a quantity. Well the quantity is if you sold 100 unit. Well that's the quantity of the unit 100 unit. And if you produce 100 unit that's the quantity 100 unit. So there's a relationship between cost volume and profit and well all what we're saying here volume do matter especially when we are dealing with variable cost. Remember variable cost varies with the number of unit produced or the number of units sold. So that's why quantity is important. The third component is profit. What is profit? Now let's think about profit. How do we make a profit? Well let's think about it for a moment. We sell something. We sell something. We have sales. Then we have to deduct from the sales the cost. Well remember what is cost? Cost we have variable cost or variable expense and fixed cost. Once we take the sale deduct our cost we should come up with our profit or net operating profit. Simply put we're going to take sales. And what is sales? Now let's break down sales. How do you know what sales is? Sales is the selling price. Whatever you're selling that unit price is times the quantity sold. How many units you sold times the price gives you sales. From the sales you are going to deduct your variable cost. What is variable cost? What's it's your variable cost per unit times how many Q quantity you sold. So Q is the same. So if you sold 10 units well you sold 10 units the variable cost of 10 units will need to be expensed or cost. Then so we have then after we deduct variable cost we deduct fixed cost and we come up with our profit and this is what I showed you right here. Sales minus variable cost minus fixed cost equal to your profit. Now here's what you need to know. A term you need to know. Selling price minus variable cost equal to something called contribution margin. So selling price. So if you're selling something for $10 it has a variable cost of 4. We would say 10 minus 4 equal to 6. We say the 6 is the contribution margin per unit. Now if you're selling 100 unit you multiply this by 100. You multiply this by 100 and the contribution margin will change but nevertheless it's the same concept that's the contribution margin. So 6 is the contribution margin per unit. Now from the 6 you deduct your fixed cost let's assume fixed cost is 2. Your profit is $4. Now we can simplify this formula a little bit further why because if you notice from a mathematical perspective if this sales minus variable cost equal to the contribution margin and Q is an element common to both what we can say we can say that and by the way we before we simplify this is the contribution margin income statement. So we did this in a prior session so hopefully you are familiar with this formula nevertheless I just explained it. So here's what I do. I can simplify this formula and I can say profit equal to if this is the contribution margin. So it's the contribution margin times the quantity minus fixed cost. So this is the same as this just simplified. Now what I want you to do is to judge this formula down. I'm going to show you how to solve problems with this formula later on means in few minutes when I work a problem. So we need to look at a actual problem for this to make sense. Now if you're watching me you must be either an accounting student or a CPA candidate. I'm glad you found me if that's what you're looking for for some help in CVP. Go to my website for head lectures dot com. I offer additional resources. I can help you. The reason you're watching is because you're looking for help whether you are studying for your courses or for your CPA exam. My resources include lectures, PowerPoint slides, multiple choice, true, false, exercises. All the lessons are broken down by course and chapter so it's very easy for you to follow. My CPA resources are aligned with your Becker, Roger, Wiley, Gleam, Miles, so on and so forth. So it's very easy to follow as well. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation. Like this recording. If you're watching it means it's helping you. Please like it. It will help other share it with other connect with me on Instagram, Facebook, Twitter, Reddit, and I created a Facebook group me account called CPA exam support group. Please join us. So to illustrate the concept is to actually work an example. So we're going to be looking at Adam electronics retailer Adam sells tablets. That's what that's what he does. And this is the margin contribution margin income statement for the month of December. Adam sells for that for that month 500 unit 500 tablets and this and the selling price per unit is $500. The same. Well, what does sales equal to? Well, quantity times selling price will give us 250,000. Now Adam will need to account for variable cost. Well, variable cost is $300 per unit. We sold 300 times the quantity is 500 same as quantity above the variable cost or the variable expense. Notice if I said cost or expense, they mean the same thing. Your textbook or your CPA review course might use either expense or cost. So it's the same thing. Now when we take sales minus variable cost, remember selling price minus contribution margin sales, whether it's times quantity or not, it doesn't really make a difference. Okay, that's going to give us contribution margin. So this is the total contribution margin for this company for the month of December. And this is the contribution margin per one unit. So each unit that Adam sells, he'll have a contribution margin of $200. Now from the contribution margin, the company will deduct door fixed expenses. What are fixed expenses? Rent expense, tax expense, insurance, utility, so on and so forth. So they will deduct door fixed expenses. And from their fixed expenses, we come up with net operating income. Again, this is the contribution margin income statement that you need to be familiar with. But here we need to focus a little bit more on the concept of contribution margin because that's very important. Contribution margin is needed for Adam. Why is the contribution margin is needed? To cover his fixed expenses. Otherwise, he would not have any profit. So Adam will need to have at least 80,000 of contribution margin. Otherwise, we'll not have a profit. Why 80,000? Because the fixed expenses are 80,000. Give me 80,000 or I'm going to be not profitable. Okay, so the contribution margin per unit is $200. So it's very important to understand what does this 200 means. So I'm going to have to explain it to you. Think about a bucket. So we have a bucket. So I'm going to just kind of draw a bucket. I'm not really good at drawing, but you guys will get the point. So this is a bucket. And this bucket is called fixed cost bucket, fixed cost or fixed expenses. And this bucket is $80,000, needs $80,000. What does that mean? It means before Adam makes a profit. And this is the profit bucket. This is the profit bucket. This is the profit. Before Adam starts to make a profit, simply put, let's assume there's a basically, once this is filled, it will go to the profit. So what does that mean? It means for every unit we sell, we put here $200, $200, $200, $200. We keep on this $200 will keep on going toward the fixed cost until the fixed cost is, the fixed cost bucket is full. Once the fixed cost bucket is full, if we add $200, it's going to go to the profit bucket because the fixed cost has been filled. So that's why it's very important to understand the role of the contribution margin per unit. Now we can now compute how many $200 do we need to fill out the bucket? How many? How many do we need to fill out the bucket to complete our fixed cost? Well, simply put, if we need, if we know our fixed cost is $80,000, $80,000 divided by $200, which is the contribution margin per unit, what does that mean? It tells us we need 400 tablets. Once we sell 400 tablets, if this is empty, once we sell, so 200 times 400, whoops, let me go back to the, and draw the bucket. Okay. So once we sell 400 buckets, 400 tablets, the bucket of fixed cost is filled and every additional unit we sell, it's going to put the 200 in the profit bucket. So this is the importance of it. So let me show you exactly what does it look like from a contribution margin income statement, assuming we sell 400 units. If we sell 400 units, 400 units times 500, our sales is $200,000, variable expenses, $300 per unit times 400 unit, $120,000, our contribution margin is $80, and voila, fixed expense is $80, we don't make any profit. So at this point, what happened is this, that fixed cost bucket is filled. We fill out that fixed cost bucket. So if we sold 400 unit, I showed you it, we'll fill it. So this is called also the break even point, which is profit equal to zero. And when does the profit equal to zero? We'll talk about the break even in a separate recording is when the contribution margin equal to the fixed cost, the total contribution margin, not only the contribution margin, because the contribution margin per unit is only $200. Now what happened if we sell one tablet above 400? Now if we sell one tablet above 400, for each tablet, we make a profit of $200, because well, once the 200 gets here, it doesn't fit in this bucket anymore. So it's going to go to the profit bucket. So the 200 will go here. And this is what we mean by for each additional unit. Now if we want to know how much profit would Adam make if he sells 440,000 tablets, it's easy. We'll take 40 units. Why 40? Because 400 is for the fixed cost. The additional 40 is the profit. So the 40 times 200 per unit will give us $8,000. No need for the contribution margin income statement. However, I'm going to use the formula that I showed you earlier, that we computed. We said profit equal to the contribution margin times quantity minus fixed cost. Well, the contribution margin per unit is $200. I switched them. The quantity is 440. So 440 times 200 minus 80 will give us $88,000 in profit. So this is equal to $88,000. If we take 440 units times 200 will give us $88,000 minus $80,000 will give us profit of $8,000. So notice how basically we could go back and I told you to copy that formula down. Now bear in mind, we make certain simplifying assumption when we are performing those CVP cost volume profit analysis, I need to explain them to you because you might see them in a multiple choice question. So it's very important to be familiar with them. One is this. Selling price does not change with volume and this is not really true in the real world. What does that mean? So those are simplifying assumptions so we can understand this process. What does that mean? Sometime when you sell more, if you have a demand for your product, you might increase the price. Here we're assuming the price does not change. The opposite is true. If you don't have enough demand, you might lower the price. We don't assume this. We assume that all costs are strictly either variable and fixed and that's not also true in the real world and we talked about this when we talked about how costs behave, variable versus fixed. But for our purposes, we keep it simple. It's either variable 100% variable or 100% fixed and we assume later on when we do multi-product company sales, when we have more than one product selling, we assume the sales mix is constant. So if we have two, three product, product A and product B, we assume we're selling for example, 30% of product A and 70% of product B for the sales mix and that's not really true also in the real world. But in the real world, the software Excel sheet algorithm will make adjustments. 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