Copyright © 2003 Pearson Education Canada Inc. Slide 3-28 Chapter 3 Cost-Volume-Profit Analysis

Copyright © 2003 Pearson Education Canada Inc. Slide 3-29 Cost-Volume-Profit Analysis Examines the behaviour of total revenues, total costs, and operating income as changes occur in the output level, selling price, variable costs or fixed costs Assumptions of CVP Analysis 1.revenues change in relation to production and sales 2.costs can be divided in variable and fixed categories 3.revenues and costs behave in a linear fashion 4.costs and prices are known 5.if more than one product exists, the sales mix is constant 6.we can ignore the time value of money Page 67

Copyright © 2003 Pearson Education Canada Inc. Slide 3-30 Contribution Margin Contribution margin is equal to the difference between total revenue and total variable costs Contribution margin per unit =Selling price - Variable cost per unit Contribution margin percentage =Contribution margin per unit / selling price per unit Pages Revenue$200$400100% Variable costs % Contribution margin$80$16040% Total for Per Unit2 units%

Copyright © 2003 Pearson Education Canada Inc. Slide 3-31 Contribution Margin Income Statement Packages Sold Revenue$0$200$400$5,000$8,000 Variable costs ,0004,800 Contribution margin ,0003,200 Fixed costs2,0002,0002,0002,0002,000 Operating income$(2,000)$(1,920)$(1,840)$0$1,200 Income statement that groups line items by cost behaviour to highlight the contribution margin Page 69

Copyright © 2003 Pearson Education Canada Inc. Slide 3-32 Breakeven Point Quantity of output where total revenues equal total costs Point where operating income equals zero Breakeven point in units =Fixed costs / Contribution margin per unit =$2,000 / $80 = 25 units Breakeven point in dollars =Fixed costs / contribution margin % =$2,000 / 40% = $5,000 Page 71

Copyright © 2003 Pearson Education Canada Inc. Slide 3-33 Cost-Volume-Profit Graph $10,000 $8,000 $6,000 $4,000 $2,000 $ Units Sold Total revenues line Breakeven Point 25 units Operating income Operating loss Page 72 Total costs line

Copyright © 2003 Pearson Education Canada Inc. Slide 3-34 Target Operating Income For most firms in the private sector, the main objective is not to breakeven Convert after-tax desired net income to its before-tax equivalent operating income Target operating income =Target net income / (1 - tax rate) Target Unit Sales =(Fixed costs + Target operating income) / Contribution margin per unit Target Dollar Sales = (Fixed costs + Target operating income) / Contribution margin % Pages

Copyright © 2003 Pearson Education Canada Inc. Slide 3-35 Sensitivity Analysis sensitivity analysis is a “what-if” technique that examines how a result will change if the original predicted data are not achieved or if an underlying assumption changes What will happen to operating income if volume declines by 5%? What will happen to operating income if variable costs increase by 10% per unit? sensitivity analysis broadens management’s perspectives about possible outcomes Pages

Copyright © 2003 Pearson Education Canada Inc. Slide 3-36 Alternative Cost Structures CVP helps managers assess the risks and potential benefits of adopting alternative cost structures Pages Example: Alternative rental arrangements Option 3 20% Commission Rev Cost $ Units Breakeven = 0 units Option 2 $1,400 Fixed Fee + 5% Commission Rev Cost $ Units Breakeven = 20 units Option 1 $2,000 Fixed Fee Rev Cost $ Units Breakeven = 25 units

Copyright © 2003 Pearson Education Canada Inc. Slide 3-37 Revenue Mix Revenue mix (or sales mix) is the relative combination of quantities of products or services that make up total revenue Sales mix of Do-All : Superword = 2 : 1 Breakeven point in units = 30 units 20 units of Do-All 10 units of Superword Do-All Superword Pages

Copyright © 2003 Pearson Education Canada Inc. Slide 3-38 Multiple Cost Drivers In many cases there may be multiple cost drivers Do-All Software Example Variable costs:$40 per software package sold $15 per invoice issued Operating income = Revenue – ($40 x packages sold) – ($15 x invoices issued) – Fixed costs In cases where there are multiple cost drivers there are multiple breakeven points Pages

Copyright © 2003 Pearson Education Canada Inc. Slide 3-39 Contribution Margin & Gross Margin Merchandising Sector Pages Contribution Margin Format Revenues$200 Variable costs: Cost of goods sold$120 Other variable43163 Contribution margin37 Fixed costs: Cost of goods sold5 Other fixed1924 Operating income$13 Gross Margin Format Revenues$200 Cost of goods sold (120+5)125 Gross margin75 Operating costs (43+19)62 Operating income$13

Copyright © 2003 Pearson Education Canada Inc. Slide 3-40 Contribution Margin & Gross Margin Manufacturing Sector Pages Contribution Margin Format Revenues$1,000 Variable costs: Manufacturing$250 Non-manufacturing Contribution margin480 Fixed costs: Manufacturing160 Non-manufacturing Operating income$182 Gross Margin Format Revenues$1,000 Cost of goods sold ( )410 Gross margin590 Non-manufacturing ( )408 Operating income$182

Copyright © 2003 Pearson Education Canada Inc. Slide 3-41 Decision Models and Uncertainty Managers make predictions and decisions in a world of uncertainty Estimate events that are likely to occur and assign probabilities to each outcome Probability distribution describes the likelihood of each mutually exclusive and collectively exhaustive set of events (must add to 1.00) Expected value is a weighted average of the outcomes with the probability of each outcome serving as the weight Pages

Copyright © 2003 Pearson Education Canada Inc. Slide 3-42 Uncertainty Example Proposal A: Spy Novel Page Probability Cash Inflow ($000,000) Expected value = (0.1*$300,000) + (.02*$350,000) + (.04*$400,000) + (0.2*$450,000) + (0.1*$500,000) =$400,000