Chapter 3

The Contribution Format Used primarily for external reporting. Used primarily by management.

Practice… (a) (b) (c) (d) (e) (f) Per Unit Var. Cost Total Total Total Operating Selling Per Units CM Fixed Income Price Unit Sold Costs $30 120,000 $720,000 $640,000 $ 10 $6 100,000 $320,000 $9 80,000 $ 160,000 $120,000

Contribution-Margin Ratio Sales revenue, variable expenses and contribution for Micro Wave can be expressed as a percentage of sales

Contribution Margin Method to Determine Break-even 3-6 Contribution Margin Method to Determine Break-even The contribution margin method has two key equations. Fixed expenses CM per unit = Break-even point in units sold The contribution margin method has two key equations: Break-even point in units sold equals Fixed expenses divided by CM per unit, and Break-even point in sales dollars equals Fixed expenses divided by CM ratio. Fixed expenses CM ratio = Break-even point in total sales dollars

CVP Graph Total Sales Total Expenses Dollars Fixed expenses Units

CVP Graph Profit Area Dollars Break-even point Loss Area Units

Break-even Reduction Micro is currently selling 500 ovens per month. Break-even units are 400 per month under the current cost structure. What would be the break-even units if fixed costs decrease to $70,000? What would be the break-even units if variable costs were reduced to $250? What would be the break-even units if selling price was increased to $513.33?

Target Operating Profit Analysis 3-10 Target Operating Profit Analysis The equation and contribution margin methods can be used to determine the sales volume needed to achieve a target profit. Suppose Micro Wave Company wants to know how many ovens must be sold to earn a profit of $100,000. We can use either method to determine the revenue or units needed to achieve a target level of profit. Suppose RBC wants to earn net income of $100,000. How many bikes must the company sell to achieve this profit level?

The Contribution Margin Approach 3-11 The Contribution Margin Approach The contribution margin method can be used to determine that 900 ovens must be sold to earn the target operating profit of $100,000. Fixed expenses + Target profit CM per unit = Unit sales to attain the target profit A quicker way to solve this problem is to add the desired profits to the fixed cost and divide the total by the contribution margin per unit. Notice we get the same result of 900 bikes. $80,000 + $100,000 $200/oven = 900 ovens

After-Tax Profit Targets Net income = Operating profit – Income taxes = Operating profit – (Tax rate x Operating profit) = Operating profit (1 – Tax rate) Or Operating profit = Net income (1 – Tax rate)

After-Tax Profit Targets Fisher Company has a selling price of $40 for its only product. Variable cost per unit is $24, and fixed costs are $800,000 for the year. The Company wants to achieve an annual net income (after taxes) of $487,500. How many units must it sell if its income tax rate is 35 percent.

Should the increase in advertising be made? Sensitivity Analysis – Fixed Costs Micro Wave Co. is currently selling 500 ovens per month The sales manager believes that an increase of $10,000 in the monthly advertising budget would increase sales of ovens to 540 per month Should the increase in advertising be made?

Change in Variable Costs and Sales Volume Micro Wave management is contemplating the use of higher-quality components, which would increase variable costs by $15 per oven. However, the sales manager predicts that the overall higher quality would increase sales to 600 ovens per month. Should the higher quality components be used?

Change in Fixed Cost, Sales Price, and Sales Volume To increase sales, the sales manager would like to cut the selling price by $40 per oven and increase the advertising budget by $30,000 per month. The sales manager believes that if these two steps are taken, unit sales will increase by 60% to 800 ovens per month. Should the changes be made?

Change in Variable Cost, Fixed Cost, and Sales Volume The sales manager would like to place the sales staff on commission basis of $40 per oven sold, rather than on flat salaries that now total $10,000 per month. The sales manager is confident that the change will increase monthly sales by 15% to 575 ovens per month. Should the change be made?

Change in Regular Sales Price The company has an opportunity to make a bulk sale of 200 ovens to a wholesaler if an acceptable price can be worked out. This sale would not have any effect on the company’s regular sales. What price per oven should be quoted to the wholesaler if Micro wants to increase its Operating profits by $5,000?

The Margin of Safety Excess of budgeted (or actual) sales over the break-even volume of sales. The amount by which sales can drop before losses begin to be incurred. Margin of safety = Total sales - Break-even sales Let’s calculate the margin of safety for Micro

The Margin of Safety Micro has a break-even point of $200,000. If actual sales are $250,000, the margin of safety is $50,000 or 100 ovens.

The Margin of Safety The margin of safety can be expressed as 20% of sales. ($50,000 ÷ $250,000)

3-22 Cost Structure Cost structure refers to the relative proportion of fixed and variable costs in an organization. Managers often have some latitude in determining their organization’s cost structure. A company’s cost structure refers to the relative proportion of fixed and variable expenses. Some companies have high fixed expenses relative to variable expenses. Do you remember our discussion of utility companies? Because of the heavy investment in property, plant and equipment, many utility companies have a high proportion of fixed costs.

Cost Structure and Profitability Alpha Beta Gamma Amount % Sales $800,000 100% Variable Expenses 400,000 50% 300,000 37.5% 200,000 25% Contribution Margin 500,000 62.5% 600,000 75% Fixed Expenses Op. Income $ 100,000

Definition of Operating Leverage The relative mix of a firm’s fixed and variable costs determines its operating leverage. At a given level of sales: Degree of operating = Contribution Margin leverage Operating Income The higher a firm’s fixed cost as compared to its variable cost, the greater its operating leverage. Operating leverage acts like a multiplier. The greater the operating leverage, the greater the change in operating income for a given change in sales. Let’s calculate the operating leverage for each firm.

Application of Operating Leverage At a given level of sales, the operating leverage is a measure of how a given percentage change in sales will affect operating profits. In fact, the operating profit will increase by the operating leverage times the percentage change in sales. For a 10% increase in sales , Firm Alpha’s operating income increased 40% (4 times 10%). For a 10% increase in sales , Firm Beta’s operating income increased 50% (5 times 10%). For a 10% increase in sales , Firm Gamma’s operating income increased 60% (6 times 10%).

Pop Quiz Tasty Bagel is an snack shop in a strip mall. The average selling price of a bagel is $1.49 and the average variable expense per bagel is $0.36. The average fixed expense per month is $1,300. 2,100 bagels are sold each month on average. What is the operating leverage? a. 2.21 b. 0.45 c. 0.34 d. 2.92

Pop Quiz At Tasty Bagel the average selling price of a bagel is $1.49, the average variable expense per bagel is $0.36, and the average fixed expense per month is $1,300. 2,100 bagels are sold each month on average. If sales increase by 20%, by how much should operating income increase? a. 30.0% b. 20.0% c. 22.1% d. 44.2%

The Concept of Sales Mix 3-28 The Concept of Sales Mix Sales mix is the relative proportion in which a company’s products are sold. Different products have different selling prices, cost structures, and contribution margins. When a company sells more than one product, break-even analyses become more complex because of the relative mix of the products sold. Different products will have different selling prices, cost structures and contribution margins. Let’s expand the product line at Racing Bicycle and see what impact this has on break-even. We are going to assume that the sales mix between the products remains the same in our example.

Break-even Analysis (in Units) with Multiple Products Curl Company provides us with the following information: Fixed cost is $120,000. What is the break-even point in units? What are the sales of Surfboards and Sailboards at the break-even point?

Break-even Analysis (in Sales Dollars) with Multiple Products Curl’s Contribution Margin income statement is shown below: $150,000 $450,000 = 33.3% What is the break-even point in Sales? What are the sales of Surfboards and Sailboards at the break-even point?