analyzing cost, volume, and pricing to increase profitability chapter 3

Analyzing Cost, Volume, and Pricing to Increase Profitability

Chapter 3

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada3-2

Operating Leverage

How a small percentage increase in sales volume can produce a significantly

higher percentage increase in profitability.


Total Per UnitSales (500 units) 250,000$ 500$ Less: variable expenses 150,000 300 Contribution margin 100,000 200$

Less: fixed expenses 80,000 Net income 20,000$

Jeff's ComputersK6 Model

Determining the Contribution Margin Per Unit

Contribution margin (CM) is the difference between the sales revenue and the variable costs.


Total Per UnitSales (500 units) 250,000$ 500$ Less: variable expenses 150,000 300 Contribution margin 100,000 200$

Less: fixed expenses 80,000 Net income 20,000$

Jeff's ComputersK6 Model

CM is a measure of the amount available to cover fixed costs and

profits for an enterprise.

CM is a measure of the amount available to cover fixed costs and

profits for an enterprise.



For each additional K6 unit Jeff sells, $200 more in contribution margin will help to

cover fixed expenses and profit.




Each month Jeff must generate at least $80,000 in CM to break even.



If Jeff sells 400 units in a month, it will be operating at the break-even point.



If Jeff sells one additional unit above the break-even point, net income increases by

the amount of the contribution margin.


Determining the Break-Even Point

The break-even point is where total revenue is equal total costs.



The break-even point in units can be determined using the following

equation:

Break-Even Volumein Units

= Fixed Costs Contribution Margin Per Unit



The break-even point in units can be determined using the following

equation:



For Jeff’s K6 model computer the break-even volume in units is:

$80,000 $200

= 400 computers


Estimating the Sales Volume Necessary to Attain a Target Profit

At the break-even point profits equal zero.

Sales Volumein Units

= Fixed Costs + Desired Profit Contribution Margin Per Unit


Estimating the Sales Volume Necessary to Attain a Target ProfitJeff wants to know how many K6 computers must be sold to earn a profit

of $100,000.



Calculate volume in units:


= Fixed Costs + Desired Profit Contribution Margin Per Unit


= $80,000 + $100,000

$200Sales Volume

in Units= 900 units



Here’s the proof:


Estimating the Effects of Changes in Sales Price

Competition is forcing Jeff to consider a drop in selling price of the K6 model. What is the impact

on break-even of a drop in selling price from $500 to $460 per unit?



The new contribution per unit would be $160 ($460 - $300).




= $80,000 $160


= 500 units



Here is the proof . . .


Changes in Fixed Costs and Sales Volume

Jeff is currently selling 500 K6 computers per month. The sales manager believes that an

increase of $10,000 in the monthly advertising budget would increase sales to

540 units.

Should Jeff authorize the requested increase in the advertising budget?



Current Sales (500 units)

Projected Sales (540 units)

Sales 250,000$ 270,000$ Less: variable expenses 150,000 162,000 Contribution margin 100,000 108,000 Less: fixed expenses 80,000 90,000 Net income 20,000$ 18,000$

Current Sales (500 units)

Projected Sales (540 units)

Sales 250,000$ 270,000$ Less: variable expenses 150,000 162,000 Contribution margin 100,000 108,000 Less: fixed expenses 80,000 90,000 Net income 20,000$ 18,000$

Sales increased by $20,000, but net income decreased by $2,000..

Sales increased by $20,000, but net income decreased by $2,000..

$80,000 + $10,000 advertising = $90,000$80,000 + $10,000 advertising = $90,000



The Shortcut SolutionThe Shortcut Solution

Increase in CM (40 units X $200) 8,000$ Increase in advertising expenses 10,000 Decrease in net income (2,000)$


Cost-Volume-Profit Graph

Viewing CVP relationships in a graph gives managers a perspective that can be obtained in no other way.

Consider the following information for Jeff:



Fixed expenses

Units

Dol

lars Total Expenses

-

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

- 100 200 300 400 500 600 700 800

Total Sales


Dol

lars


-

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

- 100 200 300 400 500 600 700 800

Break-even point

Units

Profit Area

Loss Area


The Margin of Safety

The number of units (or sales dollars) by which actual sales can fall below

budgeted sales before a loss is incurred.

Margin of safety =

Let’s calculate the margin of safetyfor Jeff’s K6 model.

Budgeted Sales - Break-even sales

Budgeted Sales



Jeff has a break-even point of $200,000. If budgeted sales are $250,000, the margin of

safety is $50,000 or 100 units.



The margin of safety can be expressed as 20 percent of sales.

Margin of safety =Budgeted Sales - Break-even sales

Budgeted Sales

Margin of safety =$250,000 - $200,000

$250,000

Margin of safety = 20%


Using Contribution to Assess the Effect of Simultaneous Changes in CVP Variables

Jeff believes that by cutting the price of the K6 model by $25, sales will increase to 550 units.


Using Contribution to Assess the Effect of Simultaneous Changes in CVP Variables

Jeff believes that by cutting the price of the K6 model by $25, sales will increase to 550 units.

Profits will be reducedfrom $20,000 to

$16,250.

Profits will be reducedfrom $20,000 to

$16,250.


CVP Analysis Using the Contribution Margin RatioThe contribution margin is expressed as a

percentage of sales price.


CVP Analysis Using the Contribution Margin RatioWe can calculate the break-even point in

total sales dollars as follows:

Fixed expenses Fixed expenses CM ratioCM ratio==

Break-even point inBreak-even point intotal sales dollarstotal sales dollars

$80,000 $80,000 40%40% = $200,000= $200,000Break-even point inBreak-even point in

total sales dollarstotal sales dollars ==


CVP Analysis Using the Equation Method

Selling Price Per Unit

×Number of Units Sold

Variable Cost Per Unit

×Number of Units Sold

+ Fixed Cost=

If we let X equal the number of units, we can expressJeff’s break-even equation as:

$500X = $300X + $80,000


CVP Limitations

Selling price is constant throughout the entire relevant range.

Costs are linear throughout the entire relevant range.

In multi-product companies, the sales mix is constant.

In manufacturing companies, inventories do not change (units produced = units sold).


End of Chapter 3

We madeit!

analyzing cost, volume, and pricing to increase profitability chapter 3

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