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Agenda

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A little more vocabulary C-V-P analysis Thursday’s class Group problem solving

Vocabulary
• Gross Margin = Revenue - Cost of goods sold.

• Contribution margin = Revenue - Variable costs
• Gross margin percent = Gross margin/Revenue • Contribution margin percent = Contribution margin/Revenue

Safety margin:
• The dollar amount by which sales exceed what is required to break even. • The number of units by which sales exceed what is required to break even.

of what are believed to be the relations among the relevant decision options.Cost-Volume-Profit Analysis: A Simple Model for Evaluating Decision Options A model is always an abstraction. sometimes mathematical. . It is a representation.

Costs Revenue = SP*units sold SP = selling price Costs = FC + VC(units manufactured) FC = fixed cost VC = unit variable costs.Simple model: • The fundamental accounting equation Profit () = Revenues . .

Within this model: We are assuming that units manufactured = units sold. .

so = 0 = SP*units sold .VC*units sold = (SP .What if we want to know how much product we must sell to break even? The breakeven point is the point where profit is zero.FC .VC)*units sold .FC units sold = FC/(SP .VC) We will call units sold at = 0: BEunits .

Formula for breakeven point Note: (SP .VC) = unit contribution margin (CM) units sold at breakeven point = FC/CM or BEunits = FC/CM .

or SP * BEunits = SP*(FC/CM) Breakeven revenue = FC/(CM/SP) .Breakeven revenue Breakeven units (BEunits) * SP.

This implies that the number of units produced during the period equals the number of units sold. the inventory levels at the beginning and end of the period are the same. • The behavior of total revenue is linear (straight line). This implies that the price of the product or service will not change as sales volume varies within the relevant range. .Assumptions underlying CVP analysis • In manufacturing firms.

Assumptions underlying CVP analysis • The behavior of costs is linear (straight line) over the relevant range. b. . The efficiency and productivity of the production process and workers remain constant. and the unit variable cost remains unchanged as activity varies. Total fixed costs remain constant as activity changes. variable. or semivariable. This implies the following more specific assumptions. Costs can be categorized as fixed. a.

Assumptions underlying CVP analysis • In multi-product organizations. • This means that the product mix does not change in response to changes in production/sales volume. . the sales mix remains constant over the relevant range. when we do a single CVP analysis. we assume the products all are sold in the same market. • In multi-product organizations. Substitutes.

000 monthly fixed costs $8 ticket price. Give breakeven units and revenue . $2 variable cost per ticket.Example 1: equation approach • • • • Movie theater: $48.

Example 1 • Suppose practical capacity per month is 12. should they do it? . • Has the theater made money in December? • If they could capture 1. It is now December 30.000 customers by lowering the ticket price to $7 for New Year’s Eve.000 tickets and that the movie theater has operated at 60% capacity during December.

000 per year.000 components during the prior year. and the components are sold for $3. The company sold 5. The firm's fixed costs are $4.000.Example 2 Data: Air Safety Systems company manufactures a component used in aircraft radar systems.000 in sales for the coming year.000. and budgets 5. (Ignore taxes) . The variable cost of each component is $2.000 each.

= 5.000. .000. VC = $2. Compute the breakeven point in units. SP = $3. Compute the breakeven point in dollars.000. 2. sold prior yr.000./budgeted this yr.000 units 1.Example 2 FC = $4.

Example 2 FC = $4.000./budgeted this yr. SP = $3.000.000 units What will be the new breakeven point if fixed costs increase by 10%? .000. VC = $2. = 5. sold prior yr.000.

000.000. = 5./budgeted this yr. SP = $3.000. sold prior yr. VC = $2.000 units What was the company's operating income for the prior year? .000.Example 2 FC = $4.

/budgeted this yr.000. What will the new breakeven point be if the price is changed? . SP = $3.Example 2 FC = $4.000.500 will result in orders for 1.200 more components each year. = 5. sold prior yr. VC = $2.000 units The sales manager believes that a reduction in the sales price to $2.000.000.

= 5.000 units The sales manager believes that a reduction in the sales price to $2. SP = $3.000. Should the price change be made? . sold prior yr. VC = $2.Example 2 FC = $4.200 more components each year.000.000./budgeted this yr.000.500 will result in orders for 1.

000.000. SP = $3.000.000 units What is the company's current safety margin? How many units will Air Safety Systems need to sell if they want to achieve a profit of $2.500./budgeted this yr.Example 2 FC = $4. sold prior yr. = 5. VC = $2.000? .000.

What is the new breakeven point? What will operating income be if sales remain at the same level as last year? .Example 2 FC = $4./budgeted this yr.000.000. = 5. VC = $2.000.000 units Suppose that due to a new labor contract variable costs increase by 10%. SP = $3. sold prior yr.000.

Multiple products Parry Sound Diskettes: Economy Selling price $10 Less variable costs: Direct materials 2 Direct labor 2 Mfg. Overhead 1 Selling 2 Contribution margin $3 Standard $15 3 4 2 2 $4 Premium $25 5 6 3 2 $9 Product % of total sales 10% 50% 40% Weighted average contrib. margin (WACM) = ? .

000 units Expected Profit = E() = ? .000 80.000 $100. costs Total predicted sales Capacity $200.000 $100.000 units 100.What is expected profit? Fixed costs: Manufacturing costs Advertising Admin.

000 is expected to increase sales by 20. Should the firm spend $100.000 on additional advertising? Compute the new expected profit: = ? Compare this to profit before the change.000. .Suppose an advertising budget increase of $100.

An advertising budget increase of $150. . .05. Should the advertising budget be increased? New weighted average contribution margin: ? E() = ? .65).000 is expected to change the sales mix to (.30.

A 2% selling commission increase is expected to increase overall demand by 10. so unit contribution margins will decline. Should they do it? Selling commissions are variable costs. Change in variable costs: Economy: Standard: Premium: The new contribution margins are Economy: Standard: Premium: .000.

Should Parry Disketts increase selling commissions? New weighted average contribution margin: ? E() = ? .

000 units . (a) What is Kaplan’s breakeven point? FC = $900.000/$6 = 150.000 units (b) Unit sales at target income = ($900.000)/$6 = 190.Example 3: Kaplan Co.$17 = $6 BEunits = $900.000 + $240.000 VC = $12 + $5 = $17 CM = $23 .

000 x $6 .$900.000 = target income (b) Contribution to date = 30.000 = $210.Example 3: Kaplan Co.000 x $6 = $180.50 .000 (c) Target contribution margin = $6. (a) Last year’s income = 185.

000))/CM* CM* = $6.000) +($210.Target contribution margin: Let CM* = target contribution margin ($900.50 .000-$180.000) CM * 130.000 units = (($900.000-$85.000)  ($210.000  $85.000  $180.

Prestige • Using CVP analysis. • In addition to the financial analysis. you are asked to consider factors such as mission. and financial flexibility. marketing. strategy. . • A spreadsheet is a good way to tackle the problem.

.Prestige • I have made a worksheet available to you on the homepage to help structure your computations. • Just use it as a guideline for your spreadsheet analysis.