3 CHAPTER COST-VOLUME-PROFIT ANALYSIS AND PRICING DECISIONS photo: © Tischenko Irina/Shutterstock

3 MARKETING WANTS ANOTHER $50,000 ► What will they do with it? ► How will it affect sales volume? ► What is the impact on our bottom line?

BREAKEVEN ANALYSIS Unit Unit 3.2Unit 3.3Unit 3.4 © Tomwang112 / iStockphoto

3 WHAT DOES IT MEAN TO “BREAK EVEN” ► Total revenues = total expenses ► Profit = $0 ► There is one sales volume at which this relationship is true ► This is called the “breakeven point”

3 TO CALCULATE THE BREAKEVEN POINT ► Use the equation approach Solve for units sold, which equals the breakeven point Why is profit set to $0? Sales Revenue– Variable expenses– Fixed expenses= Operating income (SP×units sold) – (VC×units sold) – FC = $0 [(SP – VC)×(units sold)] – FC = $0 (CM/unit×units sold) – FC = $0

$20x - $16x - $168,000 = $0 x = 42,000 jerseys BREAKEVEN POINT FOR UNIVERSAL SPORTS EXCHANGE $4x - $168,000 = $0 BREAKEVEN POINT FOR UNIVERSAL SPORTS EXCHANGE

3 FC CM/Unit = Breakeven in units SHORTCUTS… $168,000 $4 = 42,000 jerseys

3 SHORTCUTS… FC CMR = Breakeven in sales $ $168, = $840,000

LET’S LOOK AT BREAK EVEN GRAPHICALLY $168,000 LET’S LOOK AT BREAKEVEN GRAPHICALLY

3 Current sales – Breakeven sales MARGIN OF SAFETY What does this mean? $1,050,000 – $840,000 = $210,000 52,500 – 42,000 = 10,500 jerseys

3 PRACTICE BREAKING EVEN Exercise 3-2

3 EXERCISE 3-2 SOLUTION c. $.80x – $.45x – $175,000 =$0 $.35x =$175,000 x =500,000 bars to breakeven 500,000 bars  $.80 per bar = $400,000 to breakeven a.$.80 - $.45 = $.35 d. The breakeven point will increase to: b.Contribution margin ratio =

C-V-P ANALYSIS Unit Unit 3.2 Unit 3.3Unit 3.4 © Tomwang112 / iStockphoto

3 LET’S REVIEW THE PROFIT EQUATION – VC×(units sold)SP×(units sold)– FC= OI

3 HOW MUCH DO I HAVE TO SELL TO MAKE $X? ► This is called the “target income” question ► Use the profit equation ► Use the breakeven formula and treat your target pretax income as additional fixed costs FC + Target Income CM / unit = required sales volume To find the sales dollars required to attain the target income, use the CMR rather than the CM / unit. (SP×units sold) – (VC×units sold) – FC = $X

3 WHAT ABOUT TARGET NET INCOME? ► You must adjust net income to pretax income ► Divide target net income by (1 - tax rate) ► Solve as before Total FC + = required sales volume CM / unit Target net income 1 – tax rate

3 TARGET PRACTICE (EXERCISE 3-10) Wimpee’s Hamburger Stand sells one burger, the Super Tuesday Burger, for $3.00. If total variable expenses are $1.75 per hamburger and total monthly fixed expenses are $25,000, how many burgers would Wimpee have to sell each month: ► To break even? ► To earn a pretax operating income of $6,000?

3 WHAT IF… Suppose Wimpee has never sold more than 21,000 Super Tuesday Burgers in a single month. ► How likely is it that he will achieve the desired $6,000 target operating income? ► What can he do to improve his chances of reaching his $6,000 target operating income?

3 CVP ANALYSIS ► Stands for cost-volume-profit ► A tool to determine the impact of changes in sales volume, costs, or sales mix on net income ► Useful for evaluating decision alternatives

3 THREE APPROACHES TO CVP ► Prepare a contribution format income statement before and after implementing the changes ► Prepare a partial contribution format income statement that includes only those items that change (called the “incremental approach”) ► Compare the current total contribution margin with the proposed total contribution margin, then adjust for changes in fixed expenses

3 CVP AND THE SUPPLY CHAIN ► How do the CVP decisions of supply chain partners affect each other? ► For example, consider the jerseys that Universal Sports Exchange purchases from C&C Sports. What happens if C&C Sports increases the selling price? What happens if Universal Sports Exchange decides to use a cheaper supplier?

3 OPERATING LEVERAGE ► Firms sometimes have the option to trade fixed costs for variable costs ► Higher levels of fixed costs introduce higher levels of risk ► Measures the magnitude of change in operating income for a given percentage change in sales revenue Degree of operating leverage = Contribution margin Net operating income

WHY DO WE CARE ABOUT OPERATING LEVERAGE? WHY DO WE CARE ABOUT OPERATING LEVERAGE

3 DO THE CVP Exercise 3-6

3 EXERCISE 3-6 SOLUTION b. Margin of safety = Current sales – Breakeven sales c.Net operating income would increase by the change in contribution margin: $100,000 .65 = $65,000 Breakeven sales = =$450,000 Margin of safety =$600,000 – $450,000 =$150,000 a.Contribution margin ratio = Variable cost ratio = =.35

3 EXERCISE 3-6 SOLUTION (CONT.) d. new variable cost = $17.50  1.16 =$20.30 new price = $50  1.1 =$55 current unit sales = = 12,000 new unit sales = 12,000 .98 = 11,760 operating income = [($55.00 – $20.30)  11,760] – $292,500 =$115,572

MULTIPRODUCT C-V-P ANALYSIS Unit Unit 3.2 Unit 3.3 Unit 3.4 © Tomwang112 / iStockphoto

3 MULTIPRODUCT CVP ► Rarely does a company produce a single product ► Since not every product will have the same contribution margin, we have a problem when more than one product is produced

3 WHAT IS “SALES MIX”? ► The “bag” or “package” of goods sold ► For example: For every dining room table sold, the company also sells 4 chairs For every computer sold, the company also sells a monitor and a printer For every pair of athletic shoes sold, Landon Sports sells 4 baseball jerseys

3 USE THE PROFIT EQUATION…WITH ADJUSTMENTS CM(jerseys) + CM(shoes) – FC = OI ProductPrice Variable Cost Contribution Margin Jerseys$20$16.00$4.00 Shoes$45$38.70$6.30

3 DETERMINE THE SALES MIX $4.00(4x) + $6.30(x) – FC = OI Product Contribution MarginSales Mix Adjusted Contribution Margin Jerseys$4.004x4x$16.00x Shoes$6.301x1x$ 6.30x $16x + $6.30x – FC = OI

3 $22.30x = $178,400 $16x + $6.30x – $178,400 = $0 CALCULATING THE BREAKEVEN POINT Product Contribution MarginSales Mix Adjusted Contribution Margin Jerseys$4.004x4x$16.00x Shoes$6.301x1x$ 6.30x x = 8,000 shoes 4x = 4(8,000) = 32,000 jerseys

3 LIMITING ASSUMPTIONS OF CVP ANALYSIS ► All costs can be divided into fixed and variable components ► All cost and profit functions are linear throughout the relevant range ► Sales mix will remain constant

3 CHANGES EXAMINED USING CVP ► Change in sales price ► Change in sales volume ► Change in variable costs per unit ► Change in fixed costs ► Change in sales mix ► Any combination of the above Remember to always use “constant” forms – SP/unit, VC/unit, Total FC – when doing CVP analysis

3 TIME TO MIX IT UP Exercise 3-14

3 EXERCISE 3-14 SOLUTION ($30 – $15)x + ($45 – $24)3x – $982,800 =0 $15x + $63x =$982,800 x =12,600 a.Kitchenware’s sales mix is 14,000 plastic pitchers and 42,000 glass pitchers, or a sales mix of 1 to 3. plastic pitchers = x = 12,600; glass pitchers = 3x = 37,800 b. ($30 – $13)x + ($45 – $24)3x – $982,800 =0 $17x + $63x =$982,800 x =12,285 plastic pitchers = x = 12,285; glass pitchers = 3x = 36,855

PRICING DECISIONS Unit Unit 3.2Unit 3.3 Unit 3.4 © Tomwang112 / iStockphoto

3 ECONOMICS OF PRICE

3 COST-PLUS PRICING ► Start with the cost to produce the product ► Add a markup to the cost to arrive at price ► Be clear about what cost you use in the markup calculation Product Cost + Markup = Sales Price

3 CALCULATING MARKUP PERCENTAGE Sales price – Cost Cost = Markup % $ $14.80 $14.80 = 35%

3 $ $12.60 = $48.60 CALCULATING PRICE USING MARKUP % Cost $ ($36.00 × 35%) = Price + (Cost × Markup %) = Price

3 ISSUES WITH COST-PLUS PRICING ► What if customers are willing to pay more than the calculated price? ► Cost-plus pricing does not recognize the value provided to the customer; it recognizes a return to the seller ► The costs of the seller’s inefficiencies are borne by the customers

3 TARGET COSTING ► Start with an estimate of the price customers will pay Subtract the desired markup The result is the target, or maximum, product cost ► This is calculated before the product is designed and manufactured ► If you can produce the product for the target cost, go forward

3 LET’S PRICE Exercise 3-18

3 EXERCISE 3-18 SOLUTION c.Pet Designs could redesign the high-end bed to reduce the cost to produce the bed; accept a lower gross margin percentage; or, not make the bed a.cost of original pet bed = $45 – $15 = $30 markup percentage = price of high-end bed = $58 × 1.5 = $87 b.current gross margin = = 1/3; COGS = 2/3 high-end bed target cost of goods sold = 2/3 × $78 = $52

3 ONE FINAL REVIEW Problem 3-20 © Beverley Vycital/iStockphoto

3 PROBLEM 3-20(A) SOLUTION TotalPer unit Sales$627,000$13.20 Less variable expenses 332, Contribution margin294,500$ 6.20 Less fixed expenses 175,000 Operating income$119,500 new sales volume: 50,000 ×.95 = 47,500 units new sales price: $12.00 × 1.10 = $13.20 current sales volume:

3 PROBLEM 3-20(B) SOLUTION TotalPer unit Sales$660,000$13.20 Less variable expenses 367, Contribution margin292,500$ 5.85 Less fixed expenses 175,000 Operating income$117,500 new sales price: $12.00 × 1.10 = $13.20 new variable cost per unit: $7.00 × 1.05 = $7.35

3 PROBLEM 3-20(C) SOLUTION TotalPer unit Sales$648,000$10.80 Less variable expenses 420, Contribution margin228,000$ 3.80 Less fixed expenses 175,000 Operating income$ 53,500 new sales price: $12.00 ×.90 = $10.80 new sales volume: 50,000× 1.20 = 60,000 units

3 PROBLEM 3-20(D) SOLUTION TotalPer unit Sales$648,000$10.80 Less variable expenses 420, Contribution margin228,000$ 3.80 Less fixed expenses 175,000 Operating income$ 53,500 new fixed expenses: $175,000 + $20,000 = $195,000

3 PROBLEM 3-20(E) SOLUTION TotalPer unit Sales$594,000$13.20 Less variable expenses 346, Contribution margin247,500$ 5.50 Less fixed expenses 200,000 Operating income$ 47,500 new sales price: $12.00 × 1.10 = $13.20 new variable cost per unit: $7.00 × 1.10 = $7.70 new fixed expenses: $175,000 + $25,000 = $200,000 new sales volume: 50,000 ×.90 = 45,000 units