Class Introduction

Beginning of Lecture 1
Lets start with some basic Operating Income
calculations as a way to get our analytical engines
roaring
 L1.1: Cost-Volume-Profit
SP = Selling Price
VCU = Variable Cost/unit Break Evean Volume Sales = Q
CMU = Contribution margin/unit π=0 The QE that makes π=0
CM% = CMU/SP
FC = Fixed cost Break even Sales = SPxQE
Q = Quantity of units sold
OI = Operating Income
TOI = Target Operating Income
TNI = TOI x (1-T)
OL = Operating Leverage

OI = SPxQ-VCUxQ-FC
TOI = (SPxQ-VCUxQ-FC)x(1-T)
OL = (QxSPxCM%)/(QxSPxCM%-FC)

The higher OL, the more FC a

corporation has!
 L1.1: Cost-Volume-Profit

SCENARIO PLANNING
S1 (Base Case) S2 S3 S4 S5 S6 S7
Q 3200 4000 4500 4000 4000 4000 Pants 4000 Shirts 8000
$ $ $ $ $ $
SP Pants $70 Shirts $20
70 70 61 70 70 70

$ $42 $42 $42

VCU $42 (32+10) $35 (25+10) Pants $42 Shirts $9
42 (32+10) (32+10) (32+10)
FC $ 84,000 $ 84,000 $ 84,000 $ 84,000 $ 84,000 $84,000 + $30,000 $ 84,000
Additonal
0 $ 10,000 0,000 $ 6,000 $ 16,000 $ 16,000 $ 16,000
Investment
π $ 5,600 $ 18,000 $ 1,500 $ 22,000 $ 12,000 $ 10,000 $ 100,000

Increase Production Expect to sell 2 shirts

Supplier of pants
Increases Increases capacity from 1500 per 1 pant. SPs=20
charges $30,000 see
Sales to Sales to to 4000 by SPp=70 VCUs=9
Combining now but lowers VCU
Description Status Quo 4000 by 4500 by expanding VCUp=42. With old cost
S2 & S4 by $7 Plus increasing
$10,000 reducing additional structure in S5 and no
capacity (54) on (52)
Advertising SP to $61 investment with additional fixed costs for
advertising
$6,000 selling the shirts
 L1.1: Cost-Volume-Profit
On Scenario S7 (Qp=4000, Qs=8000), we sold 2 shirts for every 1 pant and
each shirt has a VCUs=$9/SPs=$20 while every pant has a FC + Invest =
VCUp=$42/SPp=$70. 84,000 + 16,000
Master Equation OI= 70x4000 + $20x8000 = 100,000
- $42x4000 - $9x8000 - $100,000
OI= 100,000

TNI = OI x (1-30%) = $70,000

Tax=30%
Sales Mix
Lets restate above equations to something we can generalize to any sales mix

Right now, sales mix is 1 pant per 2 shirts we want %Pants/%Shirts

($70-$42) = CMp = $28 Sales Mix Ratio Using Pants

($20 - $9) = CMs = $11 as the Base
Sales Mix:
33% / 66%
Pants Shirts
Now, lets look at an example where you work for a company with two
divisions and where you are trying to figure out how much should
your projected operating income be for one of those divisions (the
one you currently work for) based on sales projections provided to
you by your sales team. Notwithstanding, to get to a projected
income figure, you will need to figure out a key piece of information:
how to spread indirect costs given to you for the whole company (as
indirect costs aren’t tracked by division, but only in aggregate form, in
this particular case)

We’ll first look at (1) a first order approximation. Then (2) we’ll
apportion these same indirect costs but using a slightly more involved
method called ABC (Activity Based Costing). We’ll see from this
exercise the importance of ABC to make better budgets.
 Financial
= Budget
What is it for? How is it Calculated? Key Methods

-You justify these

-To purchase
Capital Budget

investments by doing
economic assets
differential NPV's. Ex: DCF with and without investment
depreciated over
in question, and modeled
the time
NPV - NPV >0 throughout entire asset life
-Long Term
with without
Horizon
Inv Inv
+

-Predictions are made regarding

-Pays for short
- You reverse engieneer Sales Prices, Volume Sales and
Cash Budget

term expenses
how much you'll need to Costs.
incurred mostly
pay / cover your pro- -Particularly, in costs, are must
due to production
duction level (i.e. wages, resort + to using Activity Based
that is scheduled
material costs, etc…) Costing to apportion General
in 12 months
Costs
 Lets focus on the cost side for a moment

Costs Support in the

infr. to make
Touch the production
Product possible

Direct Indirect

Fixed Variable Fixed Variable

Costs Costs Costs Costs
 GENERAL OR INDIRECT COSTS

What are “general costs”, in this case?

General Costs are any costs not assigned to a particular division or product line.

These costs are kept in an aggregate pool, so one must use, for ex, ABC to spread
the costs from this “general” pool accordingly

Example:

All Indirect Direct

SP # Labor Hrs #Units Direct Labor
Costs Material

NL $ 60 36,000 80,000 $ 800,000 $1,520,000

$2,900,000
CL $ 142 14,000 20,000 $ 260,000 $ 920,000

NL = Normal Lens division

CL = Complex Lens division
 What’s the Profit Margin?

NL CL

Revenue $60 x 80,000 $142 x 20,000

DC $1,520,000 + $800,000 $920,000 + $260,000

Indirect Costs $2,900,000 x [36/(36+14)] $2,900,000 x [14/(36+14)]

Profit Income $ 392,00 $ 848,00

One possible way, as done above, is to apportion these indirect costs by labor hours
 $2.9M

Warranty & Admon $1.9M $1M Logistics

# of Batches
Total Labor Hours
Varies
wrt For production level (i.e. 320
More hours, more complexity
of 702)
(i.e. 36,000 hrs of 50,000 hrs

Calculation
$1.9M x 36/(36+14) $1M x (320/720)
$1,812,444
 Splitting the $2.9M in
Apportioning by subgroups, and using
number of Labor cost driver applicable to
Hours each

$2,088,000 $1,812,444

A 15%
Incurrancy

Wrt
Projected NL
Profits $677,556
$392,000
using each
method As before Revised 70% Higher!!

Bad apportioning of general

costs can be catastrophic!!
Can you figure out the new Profit Income for
Division CL (Complex Lens)?