Cost Behavior and Decision Making: Cost, Volume, Profit Analysis Chapter 6 Cost Behavior and Decision Making: Cost, Volume, Profit Analysis

Topics Introduction The Contribution Margin Income Statement The Contribution Margin and Its Uses

Introduction Cost-Volume-Profit Analysis (CVP) Focuses on the following factors: The prices of products or services The volume of products or services produced and sold The per-unit variable costs The total fixed costs The mix of products or services produced

The Contribution Margin Income Statement The Contribution Margin Income Statement is structured by behavior rather than by function. Sales - All Variable Costs = Contribution Margin Contribution Margin - All Fixed Costs = Net Income

Income Statements TRADITIONAL CONTRIBUTION MARGIN Sales Less: Cost of Goods Sold Variable Costs Fixed Costs Total Costs of Goods Sold Gross Profit Less: S&A Costs Total S&A Costs Net Income $1,000 350 150 $ 500 $ 50 250 $ 300 $ 200 Sales Less: Variable Costs Manuf. Costs S&A Costs Total Variable Costs Contribution Margin Less: Fixed Costs Total Fixed Costs Net Income $1,000 $350 50 $400 $600 $150 250 $200

The Contribution Margin Income Statement Key Concept The contribution margin income statement is structured to emphasize cost behavior as opposed to cost function.

Contribution Margin Per Unit Sales (100,000 units) Less: Variable Costs Contribution Margin Less: Fixed Costs Net Income Total $200,000 80,000 $120,000 40,000 $80,000 Per Unit $2.00 .80 $1.20

Contribution Margin Per Unit What if HD Inc. sold one more unit? Sales (100,001 units) Less: Variable Costs Contribution Margin Less: Fixed Costs Net Income Total $200,002.00 80,000.80 $120,001.20 40,000.00 $80,001.20 Per Unit $2.00 .80 $1.20

Contribution Margin Per Unit Key Concept For every unit change in sales, contribution margin will increase or decrease by the contribution margin per unit multiplied by the increase or decrease in sales volume.

Contribution Margin Ratio = Contribution Margin (in $) Sales (in $)

Contribution Margin Ratio Sales (100,000 units) Less: Variable Costs Contribution Margin Less: Fixed Costs Net Income Total $200,000 80,000 $120,000 40,000 $80,000 Percent 100% 40 60%

Contribution Margin Ratio Key Concept The contribution margin per unit and the contribution margin ratio will remain constant as long as sales vary in direct proportion with volume.

Contribution Margin Ratio Key Concept For every dollar change in sales, contribution margin will increase or decrease by the contribution margin ratio multiplied by the increase or decrease in sales dollars.

Contribution Margin Ratio Using either contribution margin per unit or contribution margin ratio, calculate HD Inc.’s net income (loss) when sales are 25,000 units or $50,000. Answer: 25,000 units x $1.20 cm = $30,000 or $50,000 x 60% = $30,000

The Contribution Margin and Its Uses What would happen if sales increase? Use the CM to determine the increase of net income. Then consider what must happen before sales increase. Lower sales price? Increase incentives for sales staff? Improve quality of product? Increase advertising budget?

What-If Decisions Using CVP Step 1: Define the Problem Contribution margin is not sufficient to cover fixed costs.

What-If Decisions Using CVP Step 2: Identify Objectives 1. Increase net income 2. Maintain a high-quality product

What-If Decisions Using CVP Step 3:Identify and analyze available options 1. Reduce variable costs of manufacturing the product 2.Increase sales through a change in the sales incentive structure or commissions (a variable cost) 3. Increase sales through increasing advertising (a fixed cost)

What-If Options Using CVP When variable costs are reduced, contribution margin will increase. Find less expensive supplier of raw material Reduce the amount of labor used Use lower-wage employees What would be the consequences of each?

What-If Options Using CVP Sales Less: Variable Costs Contribution Margin Less: Fixed Costs Net Income (Loss) Total $100,000 72,000 $28,000 35,000 $(7,000) Option 1 $100,000 64,800 $35,200 35,000 $200

What-If Options Using CVP Raise sales commissions on all sales above the present level by 10 percent. Sales will increase by $30,000 or 2,400 games. Additional sales commission will be $3,000.

What-If Options Using CVP Impact of increasing Sales Incentives, Sales = $130,000 Sales Less: Variable Costs Contribution Margin Less: Fixed Costs Net Income (Loss) Total $100,000 72,000 $28,000 35,000 $(7,000) Option 1 $130,000 96,600 $33,400 35,000 $(1,600)

What-If Options Using CVP Option 2A Increase net income by $5,400 by increasing the sales commission by 10 percent on all sales of more than $100,000. The new variable costs = 72% of sales up to $100,000 and 82% on all sales over $100,000.

What-If Options Using CVP Spending an additional $10,000 on advertising will increase sales by $40,000 or 3,200 games.

What-If Options Using CVP Impact of increasing Sales Incentives, Sales = $140,000 Sales Less: Variable Costs Contribution Margin Less: Fixed Costs Net Income (Loss) Total $100,000 72,000 $28,000 35,000 $(7,000) Option 3 $140,000 100,800 $39,200 45,000 $(5800)

What-If Options Using CVP Step 4: Select the best option Option 1, NI = $200 Option 2, NI = $(1,600) Option 2a, NI = $200 Option 3, NI = $(5,800) Assess risk inherent in each option Assess sensitivity of a decision to changes in key assumptions

Changes in Price and Volume If the manager changes the sales price resulting in a change in sales volume, what will be the impact on net income? Raising the sales price may decrease sales volume but the impact on total sales revenue may be offset by the increase in sales price. Decreasing the sales price may increase the sales volume without increasing total sales revenue.

Changes in Price and Volume These business strategies decisions involve individuals in many areas of an organization, such as marketing, sales, production management, and even human resources personnel for hiring decisions. The implications of a bad decision in this area can affect the firm’s bottom line.

Changes in Cost, Price and Volume Changes can be made to cost, price and volume at the same time. Changes in one almost always impact one or both of the other variables.

Break-Even Analysis Break-Even Point: the level of sales where contribution margin just covers fixed costs and consequently net income is equal to zero.

Break-Even Analysis Break-Even (units) Fixed Costs Contribution Margin Per Unit = Break-Even (Sales $) Fixed Costs Contribution Margin% =

Break-Even Graph $ Volume Revenue Break-Even Point Income Total Cost Loss Break-Even Point in $ Break-Even Point in Volume Volume

Break-Even Calculations with Multiple Products The calculation of “average” contribution margin is really a weighted average. Fixed Costs Weighted Average Contribution Margin Ratio Break-Even Point =

Break-Even Calculations with Multiple Products Pause and Reflect Imagine how difficult it is for large retail stores such as Wal-Mart or JCPenney to compute a break-even point for the entire store or company.

Break-Even Calculations with Multiple Products When using ABC, costs are classified as unit, batch, product, or facility level instead of variable or fixed. Break-Even (units) = Fixed Costs + Batch-level costs + Product-level costs Contribution Margin Per Unit

Target Profit Analysis (Before and After Tax) To determine the sales units required to achieve a Target Profit before taxes: Sales (units) = Fixed Costs + Target Profit (before taxes) Contribution Margin Per Unit

Target Profit Analysis (Before and After Tax) Multiple Product formula to reach a Target Profit: Sales (units) = Fixed Costs + Target Profit Weighted Average Contribution Margin Per Unit

Target Profit Analysis (Before and After Tax) ABC Formula to reach a Target Income: Sales (units) = Fixed Costs + Batch-level Costs + Product-level Costs + Target Profit Contribution Margin Per Unit

The Impact of Taxes If After-Tax Profit = Before-Tax Profit (1-tax rate) then Before-Tax Profit = After-Tax Profit / (1-tax rate) Therefore, to determine after-tax Target Income Fixed costs + After-Tax Profit / (1-tax rate) Contribution Margin per unit Sales in units =

The Impact of Taxes Key Concept The payment of income tax is an important variable in target profit and other CVP decisions.

The Impact of Taxes Pause and reflect What impact do income taxes have on the calculation of the break-even point?

Assumptions of CVP Analysis Selling price is constant throughout the relevant range. Costs are linear throughout the relevant range. The sales mix used to calculate the weighted average contribution margin is constant. The amount of inventory is constant.

Cost Structure and Operating Leverage Operating Leverage: The measure of the proportion of fixed costs in a company’s cost structure. It is used as an indicator of how sensitive profit is to changes in sales volume.

Cost Structure and Operating Leverage Contribution Margin Net Income Operating Leverage = Multiply OL x % increase in Sales = % increase in Net Income

Cost Structure and Operating Leverage Company A B C Sales Cont. Margin Net Income $100,000 $ 60,000 $ 20,000 $200,000 $120,000 $ 80,000 $400,000 $240,000 $200,000 Operating Leverage 60,000 20,000 120,000 80,000 240,000 200,000 = 3.0 1.5 1.2 10% Inc Sales 30% 15% 12%

Cost Structure and Operating Leverage Pause and Reflect Unlike measures of contribution margin, operating leverage changes as sales change.

Cost Structure and Operating Leverage Key Concept A company operating near the break-even point will have a high level of operating leverage and income will be very sensitive to changes in sales volume.

Variable Costing for Decision Making The only difference between absorption and variable costing is the treatment of fixed overhead. Absorption Costing: FO is treated as a product cost, and expensed when the product is sold. Variable Costing: FO is treated as a period cost and expensed as incurred.

Variable Costing for Decision Making Absorption Costing Variable Costing Sales Less: Cost of Goods Sold Variable Costs Fixed Costs Total Costs of Goods Sold Gross Profit Less: S&A Costs Total S&A Costs Net Income $1,000 350 150 $ 500 $ 50 250 $ 300 $ 200 Sales Less: Variable Costs Manuf. Costs S&A Costs Total Variable Costs Contribution Margin Less: Fixed Costs Total Fixed Costs Net Income $1,000 $350 50 $400 $600 $150 250 $200

Variable Costing for Decision Making Absorption Costing Variable Costing Product Cost Direct Material Direct Labor Variable Overhead Fixed Overhead Period Cost Sell. & Adm. Product Cost Direct Material Direct Labor Variable Overhead Fixed Overhead Period Cost Fixed OH Sell. & Adm.

Variable Costing for Decision Making Product Costs Absorption Costing Variable Costing Direct Material Direct Labor Variable Overhead Fixed Overhead Total per unit $.30 .35 .10 .30 $1.05 Direct Material Direct Labor Variable Overhead Total per unit $.30 .35 .10 $.75 .30

Differences Between Absorption and Variable Costing When units sold equal units produced, net income is the same under both costing methods. When units produced exceed units sold, absorption costing will report higher net income than variable costing. When units sold exceeds units produced, variable costing will report higher net income than absorption costing.

Variable Costing for Decision Making Key Concept Variable costing is consistent with CVP’s focus on differentiating fixed from variable costs, and provides useful information for decision making that is often not apparent when using absorption costing.

Variable Costing for Decision Making I’m ready! Bring on the costs!