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How can managers of 6Ten stores see the effects of selling a new flavor of milk during the morning rush hour, increasing milk prices, or opening stores in a new area? Cost-volume-profit (CVP) analysis examines the behavior of total revenues, total costs, and operating income as changes occur in - the output level, - the selling price, - the variable cost per unit, and/or - fixed costs of a product

Managers use CVP analysis to help answer questions such as: - How will total revenue and total costs be affected if the output level changes? - If we raise or lower selling price, how will that affect the output level? - If we expand our business into foreign markets, how will that affect costs, selling price, and output level?

CVP assumptions: - Changes in the levels of revenue and costs arise only because of changes in the number of product/service units produced and sold. The number of output units is the only revenue driver and the only cost driver - Total costs can be separated into a fixed component and a variable component - When represented graphically, the behaviours of total revenues and total costs are linear in relation to output level within a relevant range and time period - Selling price, vc per unit and fixed costs in total are known and constant

CVP assumptions: - The analysis either covers a single product or assumes that the proportion of different products when multiple products are sold will remain constant as the level of total units sold changes - All revenues and costs can be added and compared without taking into account the time value of money

- Operating income = total revenues from operations cost of goods sold and operating costs - Net income is operating income plus non-operating revenues (such as interest income) minus non-operating costs (such as interest cost) minus income taxes - Net income = operating income + non-operating revenues non-operating costs income taxes

Mamta plans to sell Do-All Software, a home-office software package, at a two-day computer convention in Ahmedabad. Mamta can purchase this software from a computer software wholesaler at Rs.120 per package, with the privilege to return all unsold packages and receive a full Rs.120 refund per package. The package will be sold for Rs.200 each. She has already paid Rs.2,000 to Computer Conventions for the booth rental for the twoday convention. Assume that there are no other costs. Booth rental cost of Rs.2,000 is a fixed cost The cost of the package Rs.120 is a variable cost

The difference between total revenues and total variable costs is called contribution margin Contribution margin = total revenues total variable costs Contribution margin per unit = selling price variable costs per unit Contribution margin = contribution margin per unit * number of units sold

0 Revenues at Rs.200 per package Variable costs at Rs.120 per package CM at Rs.80 per package Fixed costs Operating income Rs.0 0 0 2,000 (2,000)

1 Rs.200 120 80 2,000 (1,920)

5 600 400 2,000 (1,600)

25 3,000 2,000 2,000 0

40 Rs.8,000 4,800 3,200 2,000 1,200

Rs.1,000 Rs.5,000

CM percentage (CM ratio) / PV ratio = CM per unit / selling price OR = total CM / total revenue CM percentage = 80 / 200 = 0.40 or 40%

Breakeven Point (BEP) Quantity of output sold at which total revenues equal total costs Quantity of output sold at which operating income is 0 BEP tells managers how much output they must sell to avoid a loss

Breakeven Point (BEP) Revenue Total Costs = Operating Income Revenue VC FC = OI (SP * Q) (VCU * Q) FC = OI (SP * Q) (VCU * Q) = FC + OI (SP VCU) Q = FC + OI Q = (FC + OI) / (SP VCU) Q = (FC + OI) / CMU At BEP, operating income is 0 Q = FC / CMU Breakeven number of units = fixed costs / CM per unit

Breakeven Point (BEP) Breakeven number of units = fixed costs / CM per unit Breakeven number of units = 2,000 / 80 = 25 packages

25 Revenues at Rs.200 per package Variable costs at Rs.120 per package CM at Rs.80 per package Fixed costs Operating income Rs.5,000 3,000 2,000 2,000 0

Breakeven Point (BEP) Breakeven Revenues = FC / CM % = 2,000 / 0.40 = Rs.5,000

Breakeven Chart

Total Revenue

Operating income

Rs.2,000 Breakeven Revenue Rupees

BEP = 25 units

Total Cost

VC

FC FC 25 units Operating loss Units sold

Target Operating Income How many units must be sold to earn an operating income of Rs.1,200 (SP * Q) (VCU * Q) FC = OI (200 * Q) (120 * Q) 2,000 = 1,200 200 Q 120 Q = 3,200 Q = 3,200 / 80 = 40 units or packages Desired sales to earn target OI = (FC + TOI) / CMU = (2,000 + 1,200) / 80 = 40 units Revenue needed to earn TOI = (FC + TOI) / CM% = (2,000 + 1,200) / 0.40 = Rs.8,000

**Target Operating Income
**

40 Revenues at Rs.200 per package Variable costs at Rs.120 per package CM at Rs.80 per package Fixed costs Operating income Rs.8,000 4,800 3,200 2,000 1,200

Target Net Income How many units must be sold to earn a net income of Rs.960? Revenue VC FC = OI Target Net Income = OI Income Tax Target NI = OI (OI * tax rate) Target NI = OI (1 tax rate) OI = target NI / (1 tax rate) Revenue VC FC = target NI / (1 tax rate) SP * Q VC * Q FC = target NI / (1 tax rate) 200 Q 120 Q 2,000 = 960 / (1 0.40) 80 Q 2,000 = 1,600 Q = 3,600 / 80 = 45 units

**Target Net Income
**

TNI FC + Q = 1 tax rate

CMU 960 2,000 + Q = 80 1 0.40

= 45 units

**Target Net Income
**

TNI Desired revenue = FC + 1 tax rate

CM % 960 2,000 +

Q = o.40

1 0.40

= Rs.9,000

**Target Net Income
**

45 Revenues at Rs.200 per package Variable costs at Rs.120 per package CM at Rs.80 per package Fixed costs Operating income Income tax @ 40% Net income Rs.9,000 5,400 3,600 2,000 1,600 640 960

What will be effect on BEP when focusing the analysis on target net income instead of target operating income?

Using CVP Analysis for decision making Different choices can affect selling prices, VC per unit, FC, units sold, and OI CVP Analysis helps managers make this decision by estimating the expected long-term profitability of different choices CVP Analysis also helps managers decide how much to advertise whether to expand into new market how to price the product CVP Analysis evaluates how OI will be affected if the original predicted data are not achieved

Decision to advertise Suppose Mamta anticipates to sell 40 units At a sale of 40 units, Mamta s OI would be Rs.1,200 Mamta is considering placing an advertisement in Ahmedabad Mirror describing the product, its features, and her participation in Computer Conventions The advertisement will cost Rs.500 She anticipates that advertising will increase sales by 10% to 44 packages Should Mamta advertise?

Decision to advertise

40 Revenues at Rs.200 per package Variable costs at Rs.120 per package CM at Rs.80 per package Fixed costs Operating income 40 CM at Rs.80 per package Fixed costs Operating income Rs.3,200 2,000 1,200 Rs.8,000 4,800 3,200 2,000 1,200 44 Rs.3,520 2,500 1,020 44 Rs.8,800 5,280 3,520 2,500 1,020 Difference Rs.320 500 (180)

Decision to reduce selling price Having decided not to advertise, Mamta is contemplating whether to reduce selling to Rs.175 At this price she anticipates to sell 50 units At this quantity, the software whole-seller who supplies DoAll Software will sell packages to Mamta for Rs.115 per unit instead of Rs.120 Should Mamta reduce the selling price? New CM per unit= 175 115 = Rs.60 CM from lowering selling price 50 units * Rs.60 Rs.3,000 Original CM 40 units * Rs.80 Rs.3,200 Change in CM from lowering selling price (Rs.200)

Decision to reduce selling price Mamta can examine other alternatives to increase OI Such as, Simultaneously increasing advertising costs and lowering prices In each case, she will compare the changes in CM (through the effects on SP, VC and quantities of units sold) to the changes in FC

Alternative FC & VC structures Suppose Computer Conventions offers Mamta three rental alternatives: Option 1 Rs.2,000 fixed fee Option 2 Rs.800 fixed fee plus 15% of convention revenues Option 3 25% of convention revenues with no fixed fee

Option # 1

0 (Rs.) Revenues at Rs.200 per package Variable costs at Rs.120 per package CM at Rs.80 per package Fixed costs Operating income 0 0 0 2,000 (2,000) 16 (Rs.) 3,200 1,920 1,280 2,000 (720) 20 (Rs.) 4,000 2,400 1,600 2,000 (400) 25 (Rs.) 5,000 3,000 2,000 2,000 0 40 (Rs.) 8,000 4,800 3,200 2,000 1,200 60 (Rs.) 12,000 7,200 4,800 2,000 2,800

**Option # 2 Selling price Rs.200 VC PU= purchase price 120 + rent 15% of revenue VC PU = 120 + 20 = Rs.150 FC Rs. 800
**

0 (Rs.) Revenues at Rs.200 per package Variable costs at Rs.150 per package CM at Rs.50 per package Fixed costs Operating income 0 0 0 800 (800) 16 (Rs.) 3,200 2,400 800 800 0 20 (Rs.) 4,000 3,000 1,000 800 200 25 (Rs.) 5,000 3,750 1,250 800 450 40 (Rs.) 8,000 6,000 2,000 800 1,200 60 (Rs.) 12,000 9,000 3,000 800 2,200

**Option # 3 Selling price Rs.200 VC PU= purchase price 120 + rent 25% of revenue VC PU = 120 + 50 = Rs.170 FC Rs. 0
**

0 (Rs.) Revenues at Rs.200 per package Variable costs at Rs.170 per package CM at Rs.30 per package Fixed costs Operating income 0 0 0 0 0 16 (Rs.) 3,200 2,720 480 0 480 20 (Rs.) 4,000 3,400 600 0 600 25 (Rs.) 5,000 4,250 750 0 750 40 (Rs.) 8,000 6,800 1,200 0 1,200 60 (Rs.) 12,000 10,200 1,800 0 1,800

SP VC PU CMPU Option 1 Rs. 200 Rs.120 = Rs.80 Option 2 Rs.200 Rs.150 = Rs.50 Option 3 Rs.200 Rs.170 = Rs.30 Option 1 has highest CM per unit, because of its low VC per unit Once FC are fully recovered at sale of 25 units, each additional unit sold adds Rs.80 of CM and, therefore, Rs.80 of OI per unit

The risk-return tradeoff across alternative cost structures can be measured as operating leverage Operating leverage describes the effects that FC have on changes in operating income Degree of operating leverage = CM / OI

Degree of operating leverage at sales of 40 units for three rental options Op 1 Op 2 Op 3 CM PU 80 50 30 CM 3,200 2,000 1,200 OI 1,200 1,200 1,200 Degree of operating leverage 3,200 / 1,200 2,000 / 1,200 1,200 / 12,00 2.67 1.67 1.00 DOL is specific to a given level of sales as a starting point. If the starting point changes, DOL changes. For examples for a sale of 50 units, for option 1 DOL = CM 4,000 / OI 2,000 = 2.00

**Effect of time horizon
**

In CVP analysis we assume that costs are either variable or fixed But whether a cost is variable or fixed depends on the time period for a decision The shorter the time horizon, the higher the % of total costs considered as fixed Suppose an Indian Airlines plane will depart from its gate in the next 60 minutes and currently has 20 seats unsold A potential passenger arrives from a competing airline company. What are the VC to IA of placing one more passenger in an otherwise empty seat? VC (such as one more meal) would be negligible Virtually all costs in this decision situation are fixed, such as baggage handling costs, crew costs and corporate office costs

**Effect of time horizon
**

Alternatively, suppose IA wants to decide whether to include one more city in its routes This decision may have a one year planning horizon Many more costs, including crew costs, baggage handling costs and air port fees, would be regarded as variable, and fewer costs would be regarded as fixed costs in this decision, such as corporate office costs This example shows that whether a cost is fixed depends heavily on the relevant range, the length of time horizon being considered, and the specific decision situation

**Effect of sales mix
**

Mamta is now budgeting for next convention. She plans to sell two different software products- Do-All and Superword

Do-All Units sold Revenues VC CM Fixed costs Operating Income Rs.200 PU Rs.120 PU Rs.80 PU Rs.100 PU Rs.70 PU Rs.30 PU Superword Do-All 60 Rs. 12,000 7,200 4,800 Superword 40 Rs. 4,000 2,800 1,200 Total 100 Rs. 16,000 10,000 6,000 4,500 1,500

**Multiple Cost Drivers
**

Mamta is selling only one package, i.e. Do-All In addition of purchase cost, she also incurs Rs.10 per customer document preparation cost. Revenue Less: Variable costs Rs.200 * units sold Rs.120 * units sold Rs.10 * no. of customers CM Less: fixed costs OI Rs.2,000

**Multiple Cost Drivers
**

If Mamta sold 40 packages to 25 custoemrs OI = 40 * 200 40 * 120 25 * 10 2,000 = 8,000 4,800 250 2,000 = Rs.950 If Mamta sold 40 packages to 40 custoemrs OI = 40 * 200 40 * 120 40 * 10 2,000 = 8,000 4,800 400 2,000 = Rs.800 There is no unique BEP, when there are multiple cost drivers Mamta will break even if she sells 26 packages to 8 customers or 27 packages to 16 customers

B. Obama is a newly elected leader of the Democratic Party. His attitude has left many an opponent on talk shows feeling run over by a Mack truck. Media Publishers is negotiating to publish Obama s Manifesto, a new book that promises to be instant best seller. The fixed cost of producing and marketing the book will be $500,000. The variable costs of producing and marketing will be $4.00 per copy sold. These costs are before any payment to Obama. Obama negotiates an upfront payment of $3million, plus a 15% royalty rate on the net sales price of each book. The net sales price is the listed book price of $30, minus the margin paid to the bookstore to sell the book. The normal bookstore margin of 30% of the listed bookstore price is expected to apply. How many copies must Media Publishers sell to (a) break even and (b) earn a target operating income of $2 million? Examine the sensitivity analysis of the BEP to the following changes: 1.Decreasing the normal bookstore margin to 20% of the listed bookstore price of $30. 2.Increasing the listed bookstore price to $40 while keeping the margin at 30%.

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