Cost-Volume-Profit Relationships Chapter 6: Cost-Volume-Profit Relationships Cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and profit by focusing their attention on the interactions among the prices of products, volume of activity, per unit variable costs, total fixed costs, and mix of products sold. It is a vital tool used in many business decisions such as deciding what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire.

April 19, 2010 A deeper look at Contribution Analysis Break even Cost-Volume-Profit Variable Costing and Decision Making

Contribution Analysis Below is a Contribution Income Statement for the Go Fast Car Company The Contribution Margin is $52 million, $4,727 per unit, or 39% With this analysis in place, we can test different volume scenarios

Calculating Break Even Under a Contribution Analysis framework, calculating break-even becomes very straight forward Break Even Volume = Fixed Costs / Unit Contribution Margin Break Even Sales = Break Even Volume * Unit Sales Price At sales volume of $96.5 million, Go Fast Car Co will make $0 For every additional sale, the company will add $4.7k to its operating income

Contribution Margin Ratio The Contribution margin ration is: For Go Fast Car Co 52,000,000 / 132,000,000 = 39% For every additional $1 sold, the company will see 39 cents go to Operating Income Total CM Total sales CM Ratio =

Multiple Volume Scenarios & Cost Volume Profit The Variable Cost Model allows us to easily test a multitude of volume scenarios and assess the impact on income What would Operating Income be at unit sales of 20,000? Graph the company’s CVP (X axis -$s; Y axis – units)

Assumptions and Shortcomings The Contribution Model can be very helpful, but it does make a number of simplifying assumptions Selling price is constant Costs are linear Sales/product mix is constant Inventories do not change (production = sales) Ultimately, reliable models will be much more detailed Nonetheless, and certainly within certain bounds, these concepts are most helpful

Decision Making The VP Sales wants to undertake a $3 million promotional campaign How many more cars would Go Fast have to sell to justify that level of expenditure?

Decision Making Analysis of how many cars would need to be sold to justify a $3 million promotional expenditure In this case, if the VP Sales signed up to selling more than 635 incremental cars, the company should proceed The VP Sales compensation should be driven by the success of this Of course, the company would only do this for substantially more than break even

Decision Making An economist reported that demand for Go Fast’s cars is highly elastic A decrease in price of 2% would increase unit sales volume by 10% Would Go Fast Car Co be better off by doing this?

Decision Making Analysis of a 2% decrease in price resulting in 10% increase in unit sales Results in a decrease in Contribution per car, but an increase in operating income

Multi-Product Companies and Sales Mix Analysis of a multi-product company What is break-even? Which product would the company rather sell and why?

Multi-Product Companies and Sales Mix Break even sales = Fixed Costs/Contribution Ratio $53 million / .36 = $147 million The company would rather sell a car as they contribute more in absolute dollars and profitability

Review A deeper look at Contribution Analysis Break even Cost-Volume-Profit Variable Costing and Decision Making

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